What is the 'Tier 1 Capital Ratio'
The tier 1 capital ratio is the comparison between a banking firm's core equity capital and its total risk-weighted assets. A firm's core equity capital is known as its tier 1 capital and is the measure of a bank's financial strength based on the sum of its equity capital and disclosed reserves, and sometimes non-redeemable, non-cumulative preferred stock. A firm's risk-weighted assets include all assets that the firm holds that are systematically weighted for credit risk.
BREAKING DOWN 'Tier 1 Capital Ratio'Tier 1 capital for a banking firm includes the value of its common stock, retained earnings, accumulated other comprehensive income (AOCI), noncumulative perpetual preferred stock and any adjustments to those accounts. The amount of tier 1 capital a bank holds and its proportion to its risk-weighted assets are important. In times of financial distress or recession, tier 1 capital is the first to absorb losses before other investors, such as debt holders, experience losses. The tier 1 capital ratio signifies how well a bank can withstand financial distress before it becomes insolvent.
Central banks typically develop the weighting scale for different asset classes, such as cash and government securities, which have zero risk, versus a mortgage loan, which carries more risk. A banking firm's cash on hand and government securities would receive a weighting of 0% when calculating its risk-weighted assets, for example, while its mortgage loans would be assigned a 50% weighting.
The Importance of the Tier 1 Capital Ratio
Regulators use the tier 1 capital ratio to grade a firm's capital adequacy as well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized. To be classified as well-capitalized, a firm must have a tier 1 capital ratio of 6% or greater under Basel III requirements and must not pay any dividends or distributions that would affect its capital. The original threshold for the tier 1 capital ratio under Basel I was 4%. Firms that are ranked as undercapitalized or below are prohibited from paying any dividends or management fees. In addition, they are required to file capital restoration plans.
Calculating a Tier 1 Capital Ratio
A bank has $10 billion in common stock and $2 billion in retained earnings. Adding these two values together, the bank has $12 billion in tier 1 capital. After weighing its assets according to risk, the bank has $120 billion in risk-weighted assets. Dividing the $12 billion in tier 1 capital by the $120 billion in risk-weighted assets gives the bank a tier 1 capital ratio of 10%.