Calculator

Image source: Getty Images.

A bank's Tier 1 capital ratio is its core capital divided by its risk-weighted assets. Developed in its current form in the third Basel Accord, also known as Basel III, financial institutions must maintain a Tier 1 capital ratio above a certain minimum to ensure that they are protected against unexpected losses, such as those that occurred during the financial crisis.

What is Tier 1 capital?

Tier 1 capital consists of a bank's primary, or core capital. Mainly, this means the bank's disclosed reserves and common stock, and non-redeemable non-cumulative preferred stock can be included in certain calculation methods.

Tier 1 capital is different from Tier 2 capital, which is the bank's supplementary capital such as loan-loss and revaluation reserves, as well as undisclosed reserves. Tier 2 capital is generally less reliable or secure than Tier 1 capital, and therefore must be considered separately when evaluating the riskiness of a bank.

How the Tier 1 Capital Ratio is calculated

The Tier 1 capital ratio is a bank's core equity capital as described in the previous section, divided by its total risk weighted assets and expressed as a percentage.

Tier

The Basel Committee set guidelines for risk-weighting assets, and the risk weight can range from 0% for assets such as cash to well over 100% for certain types of loans and other exposures.

As a simplified example, let's say that a bank has $100 in core capital and $2,000 in outstanding loans which have a risk weighting of 80%. Therefore, the bank's Tier 1 capital ratio can be calculated as:

Tier

Further, there are two ways a Tier 1 capital ratio can be expressed:

  • Tier 1 total capital ratio: includes all of a bank's core capital.
  • Tier 1 common capital ratio: Also known as the common equity Tier 1 ratio, or CET1 ratio, this excludes preferred shares and non-controlling interests from the total Tier 1 capital amount. For this reason, this will always be less than or equal to the total capital ratio.

Tier 1 capital requirements

Under the Basel Accords, the bank's minimum capital ratio requirement is set at 8%, and 6% must be in the form of Tier 1 capital. The 6% Tier 1 ratio must be composed of at least 4.5% of CET1, with the remainder coming from other forms of Tier 1 capital.

When the Basel III requirements are fully implemented in 2019, banks will have to hold a mandatory "capital conservation buffer" equal to 2.5% of the bank's risk-weighted assets, which brings the total minimum CET1 to 7% at that point (4.5% plus 2.5%). In addition, regulators can require an additional capital buffer of up to 2.5% of risk-weighted capital, which must be met with CET1 capital, during periods of high credit growth.

Real-world example

As a real-world example, consider the following information from Bank of America's (NYSE: BAC) second-quarter 2016 earnings presentation:

Bac Tier

Source: Bank of America Q2 2016 earnings presentation.

If you divide each of the capital figures listed by its corresponding risk-weighted assets, you can confirm the bank's calculations for its CET1. The bank is well above the minimum requirement. The phrase "fully phased-in" is used because the Basel III requirements are currently being phased in, and will be completely implemented in 2019.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com . Thanks -- and Fool on!

Matthew Frankel, who wrote this article, owns shares of Bank of America. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.