DEFINITION of 'Common Equity Tier 1 (CET1)'

A component of Tier 1 capital that consists mostly of common stock held by a bank or other financial institution. Common Equity Tier 1 (CET1) is a capital measure that was introduced in 2014 as a precautionary measure to protect the economy from a financial crisis. It is expected that all banks should meet the minimum required CET1 ratio of 4.50% by 2019.

BREAKING DOWN 'Common Equity Tier 1 (CET1)'

Following the 2008 financial crisis, the Basel Committee formulated a reformed set of international standards to review and monitor the capital adequacy of banks. These standards, collectively called Basel III, compare a bank’s assets with its capital to determine if the bank could stand the test of a crisis. Capital is required by banks to absorb unexpected losses that arise during the normal course of the bank’s operations. The Basel III framework tightens the capital requirements by limiting the type of capital that a bank may include in its different capital tiers and structures. A bank’s capital structure consists of Tier 2 capital, Tier 1 capital, and common equity tier 1 (CET1) capital.

Tier 1 capital is calculated as common equity tier 1 (CET1) capital plus additional Tier 1 capital (AT1). Common equity Tier 1 comprises of a bank’s core capital and includes common shares, stock surpluses resulting from the issue of common shares, retained earnings, common shares issued by subsidiaries and held by third parties, and accumulated other comprehensive income (AOCI). Additional Tier 1 capital is defined as instruments that are not common equity but are eligible to be included in this tier. An example of AT1 capital is a contingent convertible or hybrid security which has a perpetual term and can be converted into equity when a trigger event occurs. An event that causes a security to be converted to equity occurs when CET1 capital falls below a certain threshold.

CET1 is a measure of bank solvency that gauges a bank’s capital strength. This measure is better captured by the CET1 ratio which measures a bank’s capital against its assets. Since not all assets have the same risk, the assets acquired by a bank are weighted based on the credit risk and market risk that each asset presents. For example, a government bond may be characterized as a ‘no risk asset’ and given a zero percent risk weighting. On the other hand, a sub-prime mortgage may be classified as a high risk asset and weighted 65%. According to Basel III capital and liquidity rules, all banks must have a minimum CET1 to risk-weighted assets (RWA) ratio of 4.50% by 2019.

Common Equity Tier 1 Ratio = Common Equity Tier 1 Capital
Risk-Weighted Assets

A bank’s capital structure consists of Lower Tier 2, Upper Tier 1, AT1, and CET1. CET1 is at the bottom of the capital structure, which means that in the event of a crisis, any losses incurred are first deducted from this tier. If the deduction results in the CET1 ratio dropping below its regulatory minimum, the bank must build its capital ratio back to the required level or risk being overtaken or shut down by regulators. During the rebuilding phase, regulators may restrict the bank from paying dividends or employee bonuses. In the case of insolvency, the equity holders bear the losses first followed by the hybrid and convertible bond holders and then Tier 2 capital.

In 2016, the European Banking Authority conducted stress tests using the CET1 ratio to understand how much capital banks would have left in the adverse event of a financial crisis. The tests were done during a troubling period when a lot of banks in the Euro zone were struggling with huge amounts of non-performing loans (NPL) and declining stock prices. The result of the test showed that most banks would be able to survive a crisis in 2016.

RELATED TERMS
  1. Tier 1 Common Capital Ratio

    A measurement of a bank's core equity capital compared with its ...
  2. Tier 3 Capital

    Tertiary capital held by banks to meet part of their market risks, ...
  3. Tier 1 Leverage Ratio

    The relationship between a banking organization's core capital ...
  4. Tier 2 Capital

    One of two categories by which a bank's capital is divided. Tier ...
  5. Tier 1 Capital Ratio

    A comparison between a banking firm's core equity capital and ...
  6. Tier 1 Capital

    A term used to describe the capital adequacy of a bank. Tier ...
Related Articles
  1. Personal Finance

    Is Your Bank On Its Way Down?

    Find out how the Tier 1 capital ratio can be used to tell if your bank is going under.
  2. Personal Finance

    What's Tier 2 Capital?

    Tier 2 capital is a category of supplementary capital that banks hold.
  3. Personal Finance

    Explaining Tier 1 Capital

    Tier 1 capital refers to the core capital a bank must maintain in relation to its assets.
  4. Personal Finance

    Explaining the Tier 1 Leverage Ratio

    The Tier 1 leverage ratio measures a bank’s core capital against its total assets.
  5. Personal Finance

    Calculating the Tier 1 Capital Ratio

    The Tier 1 capital ratio is a measure of a depository financial institution’s financial health and capital adequacy.
  6. Small Business

    Understanding the Capital Adequacy Ratio

    The capital adequacy ratio (CAR) is an international standard that measures a bank’s risk of insolvency from excessive losses. Currently, the minimum acceptable ratio is 8%. Maintaining an acceptable ...
  7. Investing

    Calculating Tier 1 Common Capital Ratio

    The tier 1 common capital ratio compares a financial institution’s core equity capital to its risk-weighted assets.
  8. Investing

    Using Economic Capital To Determine Risk

    Discover how banks and financial institutions use economic capital to enhance risk management.
  9. Investing

    How Basel 1 Affected Banks

    This 1988 agreement sought to decrease the potential for bankruptcy among major international banks.
  10. Investing

    The Legacy of Basel I

    Basel I refers to a set of international banking rules enacted in 1988 by the Basel Committee on Bank Supervision.
RELATED FAQS
  1. What is the difference between tier 1 capital and tier 2 capital?

    Tier 1 capital is a bank's core capital, whereas tier 2 capital is a bank's supplementary capital. A bank's total capital ... Read Answer >>
  2. How can I calculate the tier 1 capital ratio?

    Learn about the tier 1 capital ratio, what the ratio indicates about a firm's capital adequacy and how to calculate a firm's ... Read Answer >>
  3. If my brother-in-law, who works at a pharmaceutical company, tells me about his research ...

    Discover what tier 1 capital measures about a bank. Tier 1 capital levels were mandated by Basel III following the financial ... Read Answer >>
  4. What percent of capital should banks hold relative to its risk weighted assets?

    Learn what percentage of capital banks must hold under the capital adequacy ratio as set forth in Basel III, and understand ... Read Answer >>
  5. What are some of the well-known no-load funds?

    Find out more about the capital to risk-weighted assets ratio, what the ratio measures and the formula used to calculate ... Read Answer >>
  6. How can I calculate the leverage ratio using tier 1 capital?

    Learn about the tier 1 leverage ratio, how to calculate the tier 1 capital ratio and what this leverage ratio indicates about ... Read Answer >>
Trading Center