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