FAQ on Canada's bank tax alternative

We answer some of the basic questions surrounding embedded contingent capital — a simple alternative to a bank tax, with a mouthful for a name.

As the global debate over a tax on banks to pay for future bailouts heats up, some are pitching an alternative system with a mouthful of a name — embedded contingent capital.

Below are a few answers to some of the basic questions that surround a fairly simple premise with a convoluted name.

What is embedded contingent capital?

Embedded contingent capital is the term being bandied about by Canadian finance officials as an alternative to a global tax on financial transactions. At its core, it's a way of converting debt to equity.

How does it work?

It's aimed at allowing banks to get out of short-term funding crises. Similar to a bond, embedded contingent capital is a form of debt which would convert to shares in the company once certain triggers are activated.

Triggers can be anything desired (and Canada's yet to officially reveal many specifics on the plan it will pitch to G20 officials next month) but a likely one would be the point at which regulators such as the Canada Deposit Insurance Corporation were about to step in and bail out the bank. A capital ratio that dips below 10 or five per cent could also be a trigger, for example.

The headquarters of Canada's major banks in downtown Toronto are shown. Canadian officials have repeatedly resisted calls for new taxes on Canadian banks, which withstood the recession comparatively well.

Essentially, it allows banks to wipe the slate clean of onerous debt loads by converting them into equity. Instead of having a large bill on one side of the ledger, they convert the debt to common equity, which replenishes the bank's capital level on the other side. Converting the debt to equity only after the stock has already cratered due to liquidity concerns maximizes its impact on the capital ratio.

In theory, it buys the bank time to ride out tough times, and everyone gets paid off in the end as the bank's share price rebounds. It also theoretically encourages bondholders to pay closer attention to bank management as they may end up holding diluted equity stakes in the company.

Who is in favour of it?

Canada is a strong proponent of the system. On May 18, Prime Minister Stephen Harper and five senior cabinet ministers voiced their opposition to a growing move for a global bank tax, and an ECC system is one of many alternatives that have been proposed.

Finance Minister Jim Flaherty has previously pitched an ECC-based alternative and Julie Dickson, Canada's superintendent of financial institutions, recently called the proposal the best of numerous options on the table to regulate the global financial system.

Who is against it?

In the short term, it's a bad deal for shareholders and bondholders, as neither gets quite what they thought they were paying for. Bondholders become unwilling shareholders, and existing shareholders find their stakes in the bank watered down.

Still, for some it's better than the alternatives, which would likely be having the bank collapse under its own debt, or be bailed out by public funds.

Critics have also pointed out that there is nothing inherent in an ECC system that could 100 per cent eliminate bailouts. As Dickson conceded in an April speech pitching the plan, governments could indeed be called upon to ultimately bail out a sinking ship — just that taxpayer funds wouldn't be used until the ECC triggers have kicked in and all other options have been enacted.

There's also the worry that triggering a mass influx of new equity at depressed price levels could itself trigger a new run on the bank in question. A hypothetical $50 bank share which was priced back to $10 could find itself hammered once again once a flood of new shares priced at $5 were automatically thrown into the market.

That's exactly what happened with similar instruments known as "death spiral bonds" in Japan, because the trigger point can cause an already low stock price to drop further, which creates a vicious cycle of new triggers.

Does anyone else already use it?

Not in so many words. In addition to the Japanese securities mentioned earlier, an ECC system bears many similarities with so-called "CoCo bonds" (a shorthand for "contingent capital") which are hybrids of conventional debt and equity that fall between the two under accounting rules.

Many have urged caution on the recent proliferation of CoCo bonds, as investors tend to view them as bonds (to be repaid) while it's often beneficial for companies to view them as equity (which doesn't have to be repaid). Defunct investment bank Lehman Brothers was awash in CoCo bonds when it went under in 2008, for example.

There are also concerns about their sometimes murky trigger mechanisms. A recent Standard & Poor's report said CoCo bonds should only be considered one funding option for companies, and should never replace traditional forms of debt or equity.