Canada’s big six banks continue to tap the debt and equity markets for capital at an accelerating rate, raising more than $10 billion in the last four months, despite the fact that most analysts and portfolio managers consider them to be adequately capitalized.

Experts suggest that the banks are raising capital primarily in response to market demand rather than pressure from regulators or even in response to loan losses — although those have been rising dramatically. Banks are loading up on capital in an attempt to leave no doubt in investors’ minds of their capability to ride out what appears likely to be a lengthy economic downturn.

“Given the current focus on balance-sheet strength, the market has been looking for the banks to raise capital,” says Robert Sedran, an analyst with National Bank Financial Ltd. in Toronto. “In times of great uncertainty, it’s the line of defence.”

From Nov. 1, 2008, to Feb. 28, 2009, the Big Six issued $4.7 billion in common equity, $4.1 billion in preferred shares and $1.5 billion in innovative Tier I notes, which are long-term debt instruments. That puts the total capital raised by the big banks fiscal 2009 (as of Feb. 28) at $10.3 billion, compared with $9.4 billion in capital raised by the big banks in all of fiscal 2008.

Meanwhile, the big banks’ Tier I capital ratios, the key measure of a bank’s financial strength, have been rising to the 9.5%-10.5% range, well above the 7% required by the Office of the Superintendent of Financial Institutions, the industry’s regulator. Tier I capital is a bank’s core capital, and the Tier I capital ratio represents that capital divided by a bank’s risk-weighted assets.

The consensus among analysts appears to be that the banks have enough capital on hand to weather the economic storm, and have the ability to keep Tier 1 capital ratios high, mostly by continuing to access the capital markets. They also like the fact that the banks’ Tier I capital is mostly composed of common equity, regarded as higher “quality” capital, compared with capital raised through preferred shares or Tier I notes.

“We continue to view Canadian banks as well-capitalized, even before the rush to raise capital, especially given the relative high quality of the asset side of the balance sheet, retail deposit base and capital composition,” said a Scotia Capital report on the banks issued on Feb. 11.

Some observers believe that the pressure the banks are under to raise Tier I capital ratios is a reflection of panic in the marketplace. Because of the dire plight of many global banks, investors are questioning the strength and solvency of all banks, no matter what their circumstances are.

“You can argue that the [Canadian] banks have succumbed to the effects of some of the doom-and-gloom talk,” says Dom Grestoni, senior vice president and portfolio manager at I.G. Investment Management Ltd. in Winnipeg.

Grestoni is bullish on the long-term prospects for the Canadian banks, and believes that the market’s implicit demand for higher Tier I capital ratios is overdone.

“It used to be okay to have an 8% Tier I capital ratio, then we moved to everyone expecting 9%. Now, if you don’t have 10%, your bank is viewed as having the plague or something. So I can see bank CEOs wanting to outdo one another other [in terms of raising Tier I],” Grestoni says.

With all the banks tapping the market for capital, OSFI took the somewhat unusual step late last year of publicly announcing it wasn’t pushing them to lift their capital ratio requirements. However, the regulator did change its rules governing Tier I capital by increasing the share of Tier I that could be composed of preferred shares and innovative Tier I notes to 40% from 30%, saying it wanted to give the banks more flexibility to access capital.

The pressure to raise capital isn’t all driven by market expectation, of course. To be sure, the big banks have been forced to raise capital to offset increasing loan losses. Provisions set aside in the first quarter of 2009 for expected loan losses spiked dramatically. The Royal Bank of Canada, for example, set aside loan-loss provisions of $747 million for the first quarter of 2009, up 155% from the same period last year.

@page_break@And with earnings down at all the banks, and no cuts — so far — to dividends, it’s difficult for them to strengthen their Tier I capital organically, forcing them to go to the capital markets. The good news is that, unlike global banks, Canadian banks have had no difficulty raising capital privately, and haven’t needed infusions from the government.

“They’re raising capital ahead of time, as security against a deepening recession,” says Shane Jones, managing director of Canadian equities and senior portfolio manager with Toronto-based Scotia Cassels Investment Counsel Ltd.

“They’re raising it now rather than later, when it might be more difficult,” he says.

Banks have recently shown a trend toward issuing preferred shares rather than issuing common equity because of the OSFI rule changes that allow more preferred share capital to count toward Tier 1. Also, issuing new common equity would dilute existing shareholders’ holdings.

“The last thing you want to do is dilute the common equity of shareholders,” Jones says. “You want to make sure you do the least damage to common shareholders. They’ve already been hit hard [by falling share prices].”

Observers say the banks’ preferred share issues have been finding eager buyers, both in the retail and institutional markets, as investors search for higher yields. Although dividends on the banks’ preferred shares, most recently offered in the 6.25%-6.50% range, are not as favourable as the 8%-10% yields investors can realize through the dividends on bank common stocks, the preferred share dividends are more secure.

“The public is accepting the preferred share issues, so the banks keep rolling them out,” says Robin Cornwall, president of Toronto-based Catalyst Equity Research Inc. “If the banks can get access to capital that’s non-dilutive, they’ll keep taking it.”

Some analysts believe banks are also raising capital for organic growth, including corporate lending, some analysts believe. As foreign lenders have exited the domestic market, particularly corporate borrowers, Canadians banks are benefiting from improved pricing and are seeing a modest increase in demand.

Experts don’t believe, however, that the Canadians banks are raising capital in preparation to make a significant acquisition, although smaller “tuck-in” deals might be done.

Although some tempting targets exist, particularly in the U.S. bank market, the economic outlook remains too volatile for the Canadian banks to make a move.

“It would be a challenge for any institution to make an acquisition at this time, both because of economic uncertainty and because of lack of appetite to do a big deal,” says Brenda Lum, a financial analyst with DBRS Ltd. in Toronto.

Still, some believe that the Big Six’s capital reserve, today held as a buffer against a long downturn, may allow one or more of the banks to pull the trigger on a significant acquisition down the line when the economy turns around.

Once some stability returns to the economic picture, banks might be sitting on excess capital and will be looking to deploy that, Grestoni says. IE