Tier 1 capital, under the Basel Accord, measures a bank's core capital. The tier 1 capital ratio measures a bank's financial health, its core capital relative and its total risk-weighted assets. Under Basel III, the minimum tier 1 capital ratio is 6%.
Calculate a bank's tier 1 capital ratio by dividing its tier 1 capital by its total risk-weighted assets. Tier 1 capital includes a bank's shareholders' equity and retained earnings. Risk-weighted assets are a bank's assets weighted according to their risk exposure. For example, cash would carry zero risk, but there are various risk weightings that apply to particular loans such as mortgages or commercial loans. The risk weighting is a percentage that's applied to the corresponding loans to achieve the total risk-weighted assets.
Although it appears counterintuitive, loans are considered assets for banks because banks earn revenue from loans in the form of interest from borrowers. On the other hand, deposits are liabilities since the bank pays interest to deposit holders.
Regulators use tier 1 capital ratio to determine whether a bank is well capitalized, undercapitalized, or adequately capitalized relative to the minimum requirement.
For example, bank ABC has shareholders' equity of $3 million and retained earnings of $2 million, so its tier 1 capital is $5 million. Bank ABC has risk-weighted assets of $50 million. Consequently, its tier 1 capital ratio is 10% ($5 million/$50 million), and it is considered to be well-capitalized compared to the minimum requirement.
Tier 1 Common Capital Ratio
On the other hand, bank DEF has retained earnings of $600,000 and stockholders' equity of $400,000. Thus, its tier 1 capital is $1 million. Bank DEF has risk-weighted assets of $25 million. Therefore, bank DEF's tier 1 capital ratio is 4% ($1 million/$25 million), which is undercapitalized because it is below the minimum tier 1 capital ratio under Basel III.
Bank GHI has tier 1 capital of $5 million and risk-weighted assets of $83.33 million. Consequently, bank GHI's tier 1 capital ratio is 6% ($5 million/$83.33 million), which is considered to be adequately capitalized because it is equal to the minimum tier 1 capital ratio.