Canada's financial regulator has told banks and insurance companies they must finance any big takeovers by issuing new shares, making major acquisitions more difficult just as the country's banks are at the height of their international prowess.
Issuing equity in a big deal would risk angering shareholders because their stock would be so diluted. At the same time, the banks find themselves in a state of limbo as they await the outcome of negotiations among global regulators on standard minimum capital requirements.
The edict on financing takeovers through stock issues shows just how crucial the Office of the Superintendent of Financial Institutions, Canada's regulator, deems strong capital levels to be in the wake of the financial crisis. It also helps to explain why there have been no major deals in the sector despite the strong positions of Canada's banks compared with their global counterparts.
The country's banks now enjoy a stellar profile after the crisis that devastated their peers but the moves by global regulators to bolster capital levels have muddied the waters for acquisitions.
"At this time, in light of the uncertainty as to the overall regulatory requirements down the road, the picture for the entire industry as to acquisitions is less than clear," Canadian Imperial Bank of Commerce chief executive officer Gerry McCaughey said in a recent interview.
"Over all, I believe that there is an expectation that, if major acquisitions were engaged in, until international rules are clear, share issuance would play a key role," Mr. McCaughey said.
OSFI did not issue a written notice of its edict, but has been quietly advising the banks and insurers of the requirement. OSFI has told the financial institutions it oversees that it expects them to "finance material acquisitions through new equity," spokesman Rod Giles said. "This is primarily because capital requirements are subject to significant change."
OSFI has also told banks and insurers it does not want them to increase dividends or reactivate share-buyback programs any time soon.
Analysts who cover the banks say they were not aware that the regulator had told the institutions to pay for deals with new equity, but it's likely the market would demand the same thing for any major deal because investors realize how important capital will be in the future.
"I think it's a prudent stance on behalf of the regulator given the uncertain macro-environment," said Rob Wessel, managing partner at Hamilton Capital Partners. "That being said, those same uncertainties meant significant acquisitions were unlikely anyways."
The Basel Committee, a global regulatory body, released proposed new rules in December that would increase capital requirements for banks and insurers. Discussion about the proposals will pick up this summer, and the standards are scheduled to be set at the end of this year but will not take effect until later.
The Financial Stability Board, an international group made up of central banks, government officials and regulators, has been warning since the fall that "banks should be retaining profits now to prepare to meet these future additional capital requirements. Restricting dividends, share buybacks and compensation rates is a necessary part of that process."
But there is also an effective restriction on paying for big takeovers with cash or debt, and that is part of the reason Canadian institutions have not been very active when it comes to mergers and acquisitions, executives say.
In November, Manulife Financial Corp. CEO Don Guloien decided to bolster the insurer's capital levels by raising $2.5-billion in common equity, a controversial move he said would allow the company to take advantage of acquisition opportunities. The move drove down the insurer's stock price because of the dilution to existing shareholders.
Mr. Guloien was asked on a conference call with analysts in early February whether he would now fund potential deals with common equity rather than cash.
"For small- to medium-sized deals that diversify our base of business, we feel that we have the right firepower," he said, implying that they could do it with financial resources they have on hand. "For very large deals, we have to think of other things."
The key measure of banks' capital levels, called the Tier 1 ratio, compares the amount of capital they hold with their assets (or loans), which are weighted depending on their degree of risk. OSFI currently requires banks to maintain a Tier 1 ratio of at least 7 per cent, but all of the country's major lenders far exceed that minimum requirement.
UBS analyst Peter Rozenberg has estimated Canadian banks would have about $40-billion in excess capital in 2012 over and above a Tier 1 ratio of 10 per cent.
"The Canadian banks overall are well positioned for the expected changes in regulatory capital requirements that are being discussed on a worldwide basis," CIBC's Mr. McCaughey said.
"However, we do not yet know what the conclusions of those international discussions will be and how they will apply to the Canadian jurisdiction."
In the meantime, financial institutions here are displaying an abundance of caution.