The concept of Tier 1 capital was established by the Basel Committee on Banking Supervision in its 1988 report on The International Convergence of Capital Measurement and Capital Standards. This report presented the outcome of the work done to secure convergence of supervisory regulations governing the capital adequacy of international banks with a view to strengthening the soundness and stability of the international banking system.

A second objective was that the framework should be fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality between international banks. The committee concluded that the key element of capital is equity capital and disclosed reserves. This was the only element common to all countries banking systems and was wholly visible in published accounts.

It further concluded that capital, for supervisory purposes, should be defined in two tiers in a way which required at least 50 percent of a bank’s capital base should be a core element comprised of equity capital and published reserves from post-tax retained capital (Tier 1). Other elements of capital were admitted into Tier 2 up to an amount equal to the core capital. The elements of capital are as follows:

Tier 1 Capital

• common stock
• non-cumulative preferred stock
• share premium reserve
• disclosed reserves, including retained earnings
• minority interests
• fund for general banking risks (if stated as a separate item)

Tier 2 Capital

• cumulative preferred stock
• revaluation reserves (made up of either asset revaluation or unrealized gains/losses on securities)
• subordinated debt
• undisclosed or hidden reserves
• hybrid (debt/equity) capital instruments.

Many banks that ran aground in 2008 had capital ratios well above the required minimum set by regulators; had their capital ratios been a few percentage points higher it’s unlikely they could have weathered the evaporating market confidence.

Consider that Washington Mutual had a Tier 1 capital ratio of 8.4 percent on Sept. 30, well above the 6 percent threshold that regulators use to classify a bank as well capitalized. JPMorgan Chase (NYSE: JPM), which purchased WaMu had a similar ratio of 8.9 percent. Wachovia, which agreed to sell to Wells Fargo (NYSE: WFC) in October, had a capital ratio of 7.5 percent as of Sept. 30, compared to Wells Fargo’s 8.6 percent. And National City had an 11 percent capital ratio, and yet had to sell out to PNC Financial Services (NYSE: PNC). By comparison, Bank of America (NYSE: BAC), considered one of the bedrock financial institutions, had a capital ratio at the end of the third quarter of 7.6 percent.

These numbers show that capital ratios are not a certainty in measuring health, and imposing a blanket increase will not instantly stabilize financial institutions.

But the market appears to be telling the financial sector that bigger is better these days, and all the Canadian banks are boosting their Tier 1 Capital with equity sales, partly in anticipation of rising loan losses as the economy slows in 2009.

Canada’s big banks are pumping out billions of dollars of preferred shares, and they’re being snapped up by retail investors.

Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM) recently completed a CAD325 million preferred share issue with a yield of 6.5 percent. The CIBC issue was originally set at CAD275 million when it was announced Jan. 26, but was expanded the following day “as a result of strong investor demand.”

Toronto-Dominion Bank (TSX: TD, NYSE: TD) sold CAD375 million in preferred stock yielding 6.25 percent last week, after increasing the issue from CAD275 million.

Bank of Nova Scotia (TSX: BNS, NYSE: BNS) completed a CAD325 million issue of 6.25 percent preferreds on Jan. 21, and on the same day announced an additional issue of CAD250 million, which it increased later in the day to CAD275 million.

Scotiabank, which recently raised CAD1 billion from debentures yielding 6.65 percent, recently deployed CAD270 million to increase its stake in Thailand-based Thanachart Bank to 49 percent from 25 percent.

Royal Bank of Canada (TSX: RY, NYSE: RY), after raising CAD3.2 billion in common equity late in 2008, issued CAD275 million in 6.25 percent preferreds in early January, then later in the month presented another CAD275 million issue, which almost immediately swelled to CAD350 million.

In December, Bank of Montreal (TSX: BMO, NYSE: BMO) sold CAD1 billion of new common shares and CAD450 million of notes yielding 10.2 percent that qualify as Tier 1 capital.

Canadian banks have withstood the turmoil whipped up by the financial crisis better than their US and European peers, maintaining strong Tier 1 capital ratios and keeping their heads well above water–without a government bailout.

The recently tabled federal budget does include a provision that would allow the government to buy equity in the banks, although it seems more an effort to provide the appearance of a level international playing field. Canada’s Big Five haven’t yet required government assistance, but their ability to compete with US and European banks is increased if their costs of capital are similarly limited.

It’s also noteworthy amid the current uncertainty that none of the major banks has cut a dividend since the Great Depression.

The current economic situation will challenge all financial institutions. Canadian banks have handled the first wave–the financial crisis–relatively well. The second wave–a serious economic downturn–will hit both capital and profits, but the Canadian banking system is probably better positioned than most others to ride it out.

Canada’s banks remain well capitalized, and the Office of the Superintendent of Financial Institutions has no plans to increase current capital requirements; markets have been driving capital levels up, not regulators.

Determining capital adequacy involves assessing many factors beyond Tier 1 ratios. But Canada’s conservative, deposit-based banking model has put it in good position to negotiate the current turmoil.