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 to its total risk-weighted assets (RWA). Under Basel III, banks and financial institutions must maintain a minimum Tier 1 capital ratio to ensure against unexpected losses such as those that occurred during the financial crisis of 2008. The minimum tier 1 capital ratio is 6%.
Tier 1 Common Capital Ratio
Tier 1 Capital Explained
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 carries 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. To calculate a bank's tier 1 capital ratio, divide its tier 1 capital by its total risk-weighted assets.
The minimum Tier 1 capital ratio.
Tier 2 Capital
Tier 2 capital is composed of any supplementary capital the bank has, such as loan-loss and revaluation reserves and undisclosed reserves. Tier 2 capital is considered separately in bank risk analysis because it is usually less secure than Tier 1 capital.
Tier 1 Capital Requirements
The Tier 1 capital ratio can be expressed as all of a bank's core capital or as the Tier 1 common capital ratio or CET1 ratio. The CET1 ratio excludes preferred shares and non-controlling interests from the total Tier 1 capital amount; therefore, it is always less than or equal to the total capital ratio.
Under the Basel Accords, banks must have a minimum capital ratio of 8% of which 6% must be Tier 1 capital. The 6% Tier 1 ratio must be composed of at least 4.5% of CET1.
In 2-19, the Basel III requirements will be fully implemented, and banks will need a mandatory "capital conservation buffer" of 2.5% of the bank's risk-weighted assets, which brings the total minimum CET1 to 7% (4.5% plus 2.5%). If there is high credit growth, banks may need an additional buffer of up to 2.5% of risk-weighted capital composed of CET1 capital.
Loans are Assets for Banks
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.
Identifying Whether a Bank is Well Capitalized
Regulators use the 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, the bank's tier 1 capital ratio is 10% ($5 million/$50 million), and it is considered to be well-capitalized compared to the minimum requirement.
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.