By mid-2009, years of unsustainable housing price appreciation had caused what in hindsight may be considered the biggest credit bubble in history. Banks are frequently caught up in the middle of financial debacles, and that specific crisis has been no exception. Therefore, it has become vitally important to differentiate between those who will succumb to the crisis and go bankrupt or become nationalized by the government from those that will survive and come out even stronger once conditions inevitably improve. An important measure is determining a bank's capital adequacy ratios, with the Tier 1 capital ratio front and center as governments decide who needs rescuing and investors look to profit from an uneven environment.
Tier 1 Capital Ratio Background
The Tier 1 capital ratio stems from a framework created by the Basel Committee, which was established in the 1970s by the Group of Ten (G10) industrialized nations shortly after a complicated bank liquidation. The Committee meets regularly and serves as a way for top-member central banks across the world to coordinate global banking oversight and regulation. Part of this process includes publishing research to serve as a guide to other regulatory bodies. The Basel Accords are among the most highly recognized.
The Basel I was published in 1988 and updated extensively in 2004 when Basel II was released. As you might imagine, the accords are quite extensive and cover many regulatory topics, but the primary motivation is to provide a minimum standard for capital adequacy for banks to provide an acceptable cushion and protect against potential loan and other losses. A key part of this standard is to break capital into two Tiers, the first of which is Tier 1 capital.
As defined in the Basel Accord, Tier 1 capital consists of a bank's "equity capital and published reserves from post-tax retained earnings". In very general terms, it is shareholders' equity as can be found on the balance sheet, but there are key subtractions, such as goodwill, while reserves must be fully disclosed and include items such as "share premiums, retained profit, general reserves and legal reserves." (Learn more about the Basel Accord in our article, Does the Basel Accord Strengthen Banks?)
How to Measure the Tier 1 Ratio
As you have probably already discovered, getting to a true figure for Tier 1 capital as defined by Basel is difficult, and depends on a number of factors that may be considered subjective or challenging to identify for most investors. Fortunately, this precision is not completely necessary as it is meant to serve as a guide to capital adequacy for regulators and investors alike. A Wall Street Journal article in July of 2008 sums up the challenges nicely in referring to uncertainty with calculating Tier 1 capital for JPMorgan Chase (NYSE:JPM) during the credit crisis in 2008. (If you're unfamiliar with the credit crisis, be sure to take a look at our tutorial, Credit Crisis.)
"With the Tier 1 ratio, the potential for problems lies in judgments underpinning the measure. It looks simple: the ratio compares one variation of shareholders' equity to a risk-adjusted measure of assets. The higher the Tier 1 ratio, the safer the bank. But deciding on the proper risk weighting for assets leaves the process open to subjective judgments."
During the credit crisis, there was also a debate over whether government issuance of preferred stock from the Troubled Asset Relief Program (TARP) qualified as Tier 1 because it is not purely common equity. Fortunately for investors, many publications regularly publish Tier 1 Capital figures for leading banks, and it is possible to rely on company-reported figures as many banks disclose them in quarterly and annual filings with the Securities and Exchange Commission (SEC). So while there is leeway in the manner in which Tier 1 metrics are obtained, the ratio itself is important as it lends insight into losses a bank can take before solvency becomes a serious concern. For a bank, the ratio is vitally important and could determine if it ends up being nationalized by the government during a crisis.
Acceptable Tier 1 Capital Ratios
The general consensus is that a Tier 1 capital ratio greater than 6% is acceptable, though this varies across country. The Basel Capital Accord prescribes a ratio of 8% (percentage of risk-weighted assets covered by Tier 1 and Tier 2 capital reserves), and requires 4% to be covered by Tier 1 capital.
A study by The Economist in 2009 reported that the few publicly-traded investment banking firms had Tier 1 ratios between 15% and 20%, while most money-center banks in the U.S. had ratios around 10%, implying they had further room to sustain bad commercial loans or residential mortgage write-offs before needing to raise further capital or accept any government assistance. In other words, according to Tier 1 ratios during the credit crisis of 2008, most large financial institutions would theoretically have had sufficient capital to cover potential losses.
The Tier 1 capital ratio is one of the most prominent risk measures to determine bank capital adequacy, but should be used in conjunction with other metrics to get a more complete overview of a bank's health. For example, Basel also includes a measure of Tier 2 capital that includes secondary bank capital elements, such as undisclosed reserves, hybrid debt and equity instruments, and subordinated debt . According to Basel, "the sum of Tier 1 and Tier 2 elements will be eligible for inclusion in the capital base," though certain restrictions apply on how much Tier 2 capital can be included in the overall equation – it must not exceed the amount of Tier 1 capital.
The Tier 1 capital ratio is one of many measures used to determine a bank's health but is a primary tool given its widespread use and near-universal acceptance among major regulatory financial institutions across the globe. As highlighted in the calculation section, there are many factors to consider when concluding on a precise Tier 1 ratio, but it serves as a useful guide in illuminating whether a bank can sustain further hits to its balance sheet or needs to shore up its capital base. Tracking Tier 1 levels over time is also important as it can lend insight into who is storing up capital for a rainy day or might experience a tough time due to inadequate capital levels. (Read Analyzing a Bank's Financial Statements to learn more tools to enhance your analysis.)