With the collapse and near collapse of many financial institutions globally, Canadians are undoubtedly left wondering why it is that our financial institutions (FIs) have managed to weather the storm better than many US and European institutions. The answer is at least in part due to the relatively conservative regulatory regime under which our banking system operates.

Canadian FIs are regulated by the Office of the Superintendent of Financial Institutions Canada (OSFI) and are subject to various rules and regulations intended to reduce their financialand operational risks. Included among these are rules that require FIs to maintain adequate capital to protect their depositors and other creditors from unexpected losses. In an effortto further enhance their respective capital positions, Canadian FIs have been extremely active in their capital-raising efforts in recent months, issuing a variety of securities such as common shares, preferred shares, and, to a lesser extent, subordinated debt securities.

The three primary considerations for definingthe regulatory capital of an FI for purposes of measuring capital adequacy are: (i) its permanence, (ii) its being free of mandatory fixed charges against earnings, and (iii) its subordinate legal position to the rights of depositors and other creditors of the FI.

Canadian FIs have three tiers of regulatory capital. Tier 1 capital (or core capital) comprises the highest quality capital from OSFI’s perspective, and is a core measure of a bank’s financial strength. Tier 2 capital falls short in meeting either of the first two capital properties — permanence and no mandatory charges on earnings — but contributes to the overall strength of an FI as a going concern. Tier 3 capital is used only to meet market risk capital requirements. Banks in Canada are required to maintain a minimum Tier 1 capital ratio of seven per cent (being the total Tier 1 capital expressed as a percentage of the Bank’s total risk-weighted assets), which is higher than the comparable ratio requirement imposed by several other jurisdictions, including the UK and Australia.

Tier 1 capital includes common shares, non-cumulative preferred shares, and certain so-called "innovative Tier 1 capital instruments." These innovative Tier 1 capital structures allow FIs to raise regulatory capital on a tax-effective basis.

An innovative Tier 1 capital instrument is a security issued by a special purpose vehicle (SPV) whose primary purpose is to raise capital for the FI. The SPV can be structured either through the use of an asset-based structure or as a loan-based structure.

In an asset-based structure, the SPV uses proceeds obtained from selling non-voting securities to the public to purchase a portfolio of ownership interests in debt obligations (such as residential mortgages) from its sponsoring FI. In a loan-based structure, the proceeds raised by the SPV selling non-voting securities to the public are used to acquire an inter-company debt instrument issued by the sponsoring FI to theSPV. In each case, the FI subscribes for voting securities of the SPV, giving the FI control of the SPV in legal terms.

While innovative Tier 1 capital instruments have been issued by FIs for several years, OSFI issued a new Advisory in July 2008 on Innovative Tier 1 Instruments that provided for a new form of loan-based innovative instrument to qualify for inclusion as Tier 1 capital. This new structure has helped to level the playing field between banks and insurance companies in their quest to raise capital since insurance companies are not, dueto the nature of their business, able to take advantage of asset-based structures. Under this new structure, the SPV issues a 99-year debt security to investors and uses the proceeds from issuance to acquire an inter-company debt instrument from the sponsoring FI, with maturity conditions that are the same as the public issue. In certain circumstances, in order to maintain cash resources in the FI and as a result of contractual obligations between the investors, the SPV and the FI, the public investors will receive preferred shares of the FI to satisfy interest and/or principal payments in respectof the innovative Tier 1 instruments.

Since the new Advisory was issued, over $3 billion in new loan-based innovative Tier 1 capital instruments have been issued by Canadian FIs, the majority of which has been sold to institutional investors. These recent offerings have been issued at interest rates ranging from 9.5 per cent to 10.2 per cent, thereby providing attractive rates of return as compared to government bonds or other securities traditionally issued by FIs directly. Not surprisingly, there is no shortage of demand for these instruments in the retail market, which has remained largely untapped to date. Only time will tell whether they will eventually make their way into the hands of retail investors, thereby providing a more direct opportunity for the average investor to reap the rewards of one of the world’s most financially sound banking systems.