On Canadian Banks and “Bail-ins”

Over the last four decades, financial institutions in many countries have grown to an unprecedented

scale and degree of concentration. In the 2008-09 financial crisis, a wholesale collapse of the dominant banks might have portended a freeze of credit and capital markets—without which a modern economy cannot function. Rather than entertain that risk, policymakers in countries like the U.S., U.K., and continental Europe used a combination of public funds and liquidity created by central banks to rescue several major financial corporations. In other words, these institutions were “bailed out”; the costs of their errors have since been transferred in different forms to various stakeholders, including salary-earners in both the public and private sectors, savers and pensioners, debtors, and taxpayers.

The “bail-in” alternative

On the small island nation of Cyprus, in 2013, uninsured depositors and pensioners at the country’s two largest banks faced the choice of either sacrificing a substantial portion of their savings to keep the financial institutions afloat, or losing a much greater amount in the event of a bank collapse. This is arguably the most (in)famous contemporary example of a “bail-in”—the rescue of an ailing financial institution by its own creditors.

That same year, Canada’s Conservative government proposed a “bail-in” regime for Canadian banks as part of the 2013 federal budget. In its 2016 budget, the current Liberal government offered a virtually identical proposal, and even promised a concrete policy framework to follow. On page 223:

“To protect Canadian taxpayers in the unlikely event of a large bank failure, the Government is proposing to implement a bail-in regime that would reinforce that bank shareholders and creditors are responsible for the bank’s risks—not taxpayers. This would allow authorities to convert eligible long-term debt of a failing systemically important bank into common shares to recapitalize the bank and allow it to remain open and operating. Such a measure is in line with international efforts to address the potential risks to the financial system and broader economy of institutions perceived as ‘too-big-to-fail’.”

A few key details are worthy of note here:

1.    The word “creditors” is ambiguous; it may encompass not only investors and bondholders, but depositors too.

2.    Canada is not Cyprus. Unlike the Eurozone states, our country has its own sovereign currency and central bank, which means our government needn’t go cap-in-hand to a foreign central bank to borrow in its own currency. This enables potential policy alternatives to the kind of “bail-in” that Cypriots endured. For example, the Bank of Canada could theoretically pump liquidity into insolvent banks by acting as the buyer of last resort for those banks’ bonds.

3.    Canada has an insurance program covering various categories of deposits up to $100,000 through the Canada Deposit Insurance Corporation (CDIC). But the CDIC’s total holdings amount to a small fraction of the total value of insured deposits across Canada. In the CDIC’s 2015 annual report, the ratio was $3.044 billion in cash and investments held by the agency, plus a $20 billion borrowing limit, to $684 billion in insured deposits.

4.    The government’s “bail-in” proposal doesn’t actually rectify the too-big-to-fail problem—in fact, it doesn’t even purport to do so. Rather, the stated goal of the policy is to keep “systemically important” (i.e. too-big-to-fail) institutions “open and operating”, and transfer the costs of doing so from taxpayers to bank creditors.

Assuming the proposed “bail-in” regime takes effect, would the full value of your deposits in Canada’s major banks be safe in the event of another 2008-magnitude crash?

Maybe, but not certainly. At the very least, if you have a bank account in excess of $100,000 in any of the big Canadian banks, it might be a good idea to split it so that all of your deposits remain below the CDIC-insured limit.

Why many tech startups are cheering a broken Liberal campaign promise

On March 22, Prime Minister Trudeau’s Liberal government unveiled its first federal budget since capturing a parliamentary majority in the 2015 election. Among the components of the budget that have attracted attention in the press are the fiscal stimulus measures, infrastructure investments, and a deficit projection of close to $30 billion. But the budget is also notable because of something it does not contain: changes to the taxation of stock options.

In general, Canadians who are likelier to receive compensation in the form of stock options tend to be at the high end of the earnings scale. Large firms often reward their executives with stock options in lieu of salary, partly because stock option gains benefit from preferential tax treatment, and partly because ownership of claims on their own company’s stock provides a material incentive for corporate executives to optimize that stock’s performance.

The Liberals’ original proposal was to place a cap of $100,000 per year on gains from exercised stock options that can qualify for a tax deduction. (Under the current rules, only half of gains from cashing in stock options are subject to taxation, and there is no cap.)

Why didn’t the government follow through on its pledge? And what are some of the implications of this non-change?

Startup compensation a concern

“As I was out on pre-budget consultations I heard from many small firms and innovators that they use stock options as a legitimate form of compensation for their employees, so we decided not to put that in the budget,” said Finance Minister Bill Morneau. Indeed, startups typically do not enjoy the kind of cash flow that large, profitable, established firms generate. Thus, it is common for startups, particularly in the tech sector, to try to lure talent away from major players by offering stock options as compensation. This practice has allowed some startups to attract highly skilled personnel who might otherwise have accepted a more immediately lucrative position at a reputable, old-guard company.

The Liberals were not the only federal political party to float a proposal for altering the preferential tax treatment accorded stock options in the run-up to last year’s election. Thomas Mulcair’s New Democrats actually went a step further, advocating wholesale elimination of the special deduction. But tech entrepreneurs pushed back; Hootsuite Media founder Ryan Holmes even predicted that the NDP plan would “kill the Canadian startup ecosystem.”

At a time when Canada’s economy is experiencing lacklustre growth and job creation, many leading politicians understandably don’t want to be seen as undermining one of the country’s most vibrant growth industries. Moreover, the Liberals have marketed themselves as a party that plans to green the economy through technology and innovation; a policy change to the detriment of the tech startup sector would seem out of step with that brand image.

The downside: loss of federal revenue

Of course, incumbents in many industries would be delighted to receive special subsidies, protections, and preferential tax treatment, and can mount convincing arguments in their own favour. Every policy yields costs and benefits, and it’s the task of policymakers to weigh these in order to identify the most socially beneficial option.

Preferential treatment for stock options imposes a cost on Canadian taxpayers by undercutting the amount of revenue that makes its way into federal coffers. In turn, this compromises the government’s ability to offer public services and invest in infrastructural upgrades and innovation—all of which can lower the cost of doing business and boost productivity—without increasing the deficit. Even relatively conservative tax specialists, like Jack Mintz of the University of Calgary, have argued that the status quo around stock option taxation is inefficient, and unfairly favours employees who receive stock options as compensation.

Trudeau and Morneau broke their promise because they have calculated that the status quo delivers more benefits for startups than costs for Canadians who don’t hold stock options. For now at least, a lot of tech startups will breathe a sigh of relief.