Last Thursday, Canadian Minister of Finance Jim Flaherty announced plans in the federal budget to implement a bail-in regime for systemically important banks so that future recapitalizations can be accomplished through "the very rapid conversion of certain bank liabilities into regulatory capital." In a move consistent with the global framework for domestic systemically important institutions that the G20 endorsed in November 2012, the Canadian government also confirmed that systemically important Canadian banks will face a higher, but as-yet-undetermined, capital requirement.

A bail-in regime would reduce the potential requirement for taxpayer-funded assistance, and the capital surcharge improves a bank's standalone credit quality. We will need to wait until details of the bail-in mechanism are available to evaluate how well it might operate in a bank resolution. However, an effective bail-in regime increases the government's ability to impose losses on debtholders and a lower probability of systemic support could increase bank funding costs. Taken together, the plans are credit negative for Canadian banks.

The government's budget statement did not identify which Canadian banks that regulators will deem systemically important, but we expect all six of Canada's major banks to get the designation. In order of assets, the six banks are Royal Bank of Canada (Aa3 stable; C+/a2 stable), The Toronto-Dominion Bank (Aa1 stable, B/aa3 stable), Bank of Nova Scotia (Aa2 stable; B-/a1 stable), Bank of Montreal (Aa3 stable; C+/a2 stable), Canadian Imperial Bank of Commerce (Aa3 stable; C+/a2 stable) and National Bank of Canada (Aa3 stable; C/a3 stable).

The Office of the Superintendent of Financial Institutions, the primary federal financial regulator, will determine which banks are systemically important and specify the capital each must maintain in excess of the Basel III minimum starting on January 1, 2016.

Canada's plan to establish bail-in powers is consistent with other international reforms, including the Financial Stability Board's Key Attributes of Effective Resolution Regimes for Financial Institutions, which recommends that resolution authorities have the power to write down or convert all senior unsecured and uninsured liabilities, as well as subordinated debt and preferred stock to regulatory capital. The detailed terms of the Canadian regime are not yet available, but the government has committed itself to consulting with stakeholders and a smooth transition. Consequently, we think that currently outstanding bank debt may be made exempt from bail-in conversion. Confirmation of this, as well as the exact types of liabilities that can be converted to regulatory capital, remain critical questions.

To function effectively, the power to bail in senior bank liabilities will need to mesh with the mechanism that allows Canadian authorities to convert other forms of regulatory capital to common equity at the point when an institution is no longer viable. Since Jan. 1, all Canadian banks' new subordinated debt and preferred share issuance have had to comply with Canada's Non-Viability Contingent Capital requirements in order to qualify as regulatory capital.

Under Canada's contractual model for NVCC, each instrument must have a formula governing the conversion mechanism that references the market value of equity when the federal banking regulator determines the institution is no longer viable. It remains to be seen whether "bailable" senior debt will have a similar formula governing conversion to non-common equity forms of capital. While the formula approach is transparent for market participants, the interaction of formula terms between different instruments might result in a level of complexity that makes resolution powers harder to deploy. We think the conversion formulas could also have the unintended consequence of increasing the vulnerability of banks to arbitrage trading strategies. For example, if investors shorted a bank's equity and bought its subordinated debt in anticipation of conversion, the decline in the stock price could accelerate financial distress.

William Burn is an analyst with Moody's Investors Service. This post originally appeared in the firm's March 25 Credit Outlook.