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The Tier 1 capital ratio is a measure of a depository financial institution’s financial health and capital adequacy. The ratio was developed as part of the Basel III Accords, which focused on individual bank’s liquidity coverage ratio, net stable funding ratio, the establishment of liquidity risk management supervision principles, and monitoring metrics.

The formula for calculating the Tier 1 capital ratio is:

Tier 1 Capital / Risk-Weighted Assets

A bank’s Tier 1 capital is comprised of the bank’s common stock and its retained earnings. It may also include disclosed reserves and non-redeemable, non-cumulative preferred stock.

Risk-weighted assets is the bank’s loan portfolio measured to determine the riskiness of each loan. The riskier the loan, the less it counts toward the total. For instance, a collateralized loan has less risk than an uncollateralized letter of credit.  

Regulators use the Tier 1 capital ratio to rate a financial institution’s capital adequacy. The possible ratings include well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. To be considered well capitalized, a financial institution must have a Tier 1 capital ratio of 6% or better. 

A bank with a ratio of 3% or less is considered undercapitalized. A 2% or less ratio is considered critically undercapitalized. Banks with these ratios are prohibited from paying dividends or management fees. Additionally, they must file a capital restoration plan showing how they will get their Tier 1 capital ratio to 4% or above.

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