A:

Under the Basel Accord, a bank's capital consists of tier 1 capital and tier 2 capital, and the two types of capital are different. Tier 1 capital is a bank's core capital, whereas tier 2 capital is a bank's supplementary capital. A bank's total capital is calculated by adding its tier 1 and tier 2 capital together. Regulators use the capital ratio to determine and rank a bank's capital adequacy.

## Tier 1 Capital

Tier 1 capital consists of shareholders' equity and retained earnings. Tier 1 capital is intended to measure a bank's financial health and is used when a bank must absorb losses without ceasing business operations. Under Basel III, the minimum tier 1 capital ratio is 10.5%, which is calculated by dividing the bank's tier 1 capital by its total risk-based assets.

For example for the quarterly period ended September 30, 2017, Wells Fargo & Company (WFC) had tier 1 capital of \$176.263 billion and risk-weighted assets worth \$1.243 trillion. So, the bank's tier 1 capital ratio for the period was \$176.263 billion / \$1.243 trillion = 14.18%, which met the minimum Basel III requirement of 10.5%.

## Tier 2 Capital

Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves. Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital. In 2017, under Basel III, the minimum total capital ratio is 12.5%, which indicates the minimum tier 2 capital ratio is 2%, as opposed to 10.5% for the tier 1 capital ratio.

Wells Fargo & Company reported tier 2 capital of \$32.526 billion. Its tier 2 capital ratio for the quarter was \$32.526 billion / \$1.243 trillion = 2.62%. Thus, Wells Fargo's total capital ratio was 16.80% (14.18% + 2.62%). Under Basel III, Wells Fargo met the minimum total capital ratio of 12.5%.

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