Buried deep in last month's federal budget is an ambiguously worded section that has roiled parts of the financial world but has so far been largely ignored by the mainstream media.

It boils down to this: Ottawa is contemplating the possibility of a Canadian bank failure — and the same sort of pitiless prescription that was just imposed in Cyprus.

Meaning no bailout by taxpayers, but rather a "bail-in" that would force the bank's creditors to absorb the staggering losses that such an event would inevitably entail.

If that sounds sobering, it should. While officials in Ottawa are playing down the possibility of a raid on the bank accounts of ordinary Canadians, they chose not to include that guarantee in the budget language.

Canadians tend to believe their banks are safer and more backstopped than elsewhere in the world. The federal government enthusiastically promotes the notion, and loves to take credit for it.

It may well be true, even if Canada's six-bank oligopoly isn't terribly competitive, at least in comparison to the far more diverse American banking universe.

But in the ever-more insecure world that has unfolded since the financial meltdown of 2008, it is also increasingly clear that nothing is safe anymore, not even blue-chip bank stocks and bonds or even, in the case of the Cyprus bail-in, private bank accounts.

And now, Canada is making a bail-in official government policy, too.

"The government proposes to implement a bail-in regime … designed to ensure that, in the unlikely event that a systemically important bank depletes its capital, the bank can be recapitalized and returned to viability," says Finance Minister Jim Flaherty's March 21 budget, on page 144.

That would be done, the document says, through the rapid conversion of "certain bank liabilities."

Ottawa's budget document leaves the definition of "certain liabilities" to the reader's imagination.

Bank deposits?

There has been very little public debate about the plan to date, but Finance Department officials and the banks protest it should never be taken to mean small personal deposits would be seized.

Depositors wait to enter a branch of the Laiki Bank in Nicosia on March 28. Cyprus's banks had been closed for almost two weeks as the country's financial crisis mounted, and were only opened with tight controls on transactions to prevent a further run. (Bogdan Cristel / Reuters)

Deposits are insured by the Canadian Deposit Insurance Corporation, up to $100,000, and the inviolability of that insurance is key to maintaining the crucial public trust.

"The risk of the Canadian government not honouring its insurance on deposits is as close to zero as you can get," says Craig Alexander, chief economist at TD Canada Trust.

Perhaps.

As the Cyprus meltdown proceeded, it became clear that Europe's finance ministers and central banks, encouraged by the International Monetary Fund, were not only willing to freeze and seize uninsured deposits over 100,000 euros, they were also initially willing to cancel deposit insurance and go after small depositors, too.

In the end, the plan was rewritten, and insured deposits were protected. But the signal had been sent: The Europeans and the IMF had been prepared to do the unthinkable.

Holland's finance minister then declared that bail-ins would be the template for all future bank rescues in Europe, and that he could not rule out seizure of deposits elsewhere.

"It was a monumentally stupid thing to do," says TD Canada Trust's Alexander. "I do not believe we would ever see that in Canada.

"I think the international community will have learned from their mistake. And it was a huge mistake."

High-risk bonds

So what does Canada have in mind with its proposed bail-in scheme?

The aim is virtuous: Canada wants to erase the enormous moral hazard created by the concept of "too big to fail."

Americans still burn with anger at the decision to reward irresponsible, even fraudulent bankers with trillions in public bailout money, while the rest of the country sank into recession. Canadian tax money was also used to prop up banks and the automotive industry.

In ruling out future bailouts, Ottawa's logic is simple: Make it clear there is no tax-funded safety net, and you discourage reckless behaviour, protecting taxpayers in the process.

That leaves the question, though, of how to save a sinking bank, something that would devastate the economy. (Although one has to assume that by the time a Canadian bank started sinking, the economy would already be in a nightmare.)

As things currently stand, if a big-six bank began to fail its shares would tank, and investors would lose everything. A run would begin, and the bank would flounder, desperate for capital. Credit markets would also likely freeze.

Without government intervention, the bank would be placed in receivership, and its bondholders would carve up what would be left of the bank's assets.

What Ottawa intends to propose — the concept has been discussed for a few years now in the rarefied circles of monetary experts — is the creation of a new type of higher-risk bank bond known as "contingent capital."

The bondholder would enjoy a higher-than-normal return, maybe even a much higher-than-normal return.

But it would be understood that in the event of a threatened failure, the bond would be converted to shares, meaning potentially a total loss for the bondholder, and a source of capital for the bank.

Think of it as a kind of pre-approved loan for the bank itself.

Trust in government

In a speech, Mark Carney, Canada's departing central banker, has called publicly for just such a system.

At TD Canada Trust, Alexander says this kind of system would make the banks stronger.

But he also notes that many Canadians believe, mistakenly, that their RRSPs and other holdings are safe and insured, too, up to the $100,000 threshold.

They don't often realize that government bonds as well as stocks and mutual funds are among the investments that don't qualify for CDIC insurance.

As to whether small, insured deposits are safe in the event of a failure, that boils down to a question of trust in government.

Christine Lagarde, head of the IMF, was prepared to seize a portion of all deposits in Cyprus. So was the European Central Bank, and so were Europe's finance ministers.

Holland's finance minister, who led the euro-group effort, later "clarified," his statement about seizing deposits elsewhere, saying that Cyprus was clearly a "one-off" event.

But then so, supposedly, was the massive haircut imposed on the unfortunate holders of Greek sovereign bonds last year.

The fact is, if Ottawa is seriously contemplating the failure of a Canadian bank, ordinary Canadians might want to do the same, and govern themselves accordingly.