What Is Common Equity Tier 1 (CET1)?
Common Equity Tier 1 (CET1) is a component of Tier 1 capital that is primarily common stock held by a bank or other financial institution. CET1 is a capital measure that was introduced in 2014 as a precautionary way to protect the economy from a financial crisis, largely in the context of the European banking system. All Eurozone banks are expected to meet the minimum CET1 ratio requirements to their risk-weighted assets (RWAs) as outlined by financial regulators.
- Common Equity Tier 1 covers liquid bank holdings such as cash and stock.
- The CET1 ratio compares a bank's capital against its assets.
- Additional Tier 1 capital is composed of instruments that are not common equity.
- In the event of a crisis, equity is taken first from Tier 1.
- Many bank stress tests against banks use Tier 1 capital as a starting measure to test the bank's liquidity and ability to survive a challenging monetary event.
Understanding Common Equity Tier 1 (CET1)
The Basel Committee formulated a reformed set of international standards to review and monitor banks' capital adequacy following the 2007-2008 financial crisis. These standards, which are collectively called Basel III, compare a bank’s assets with its capital to determine if the bank could stand the test of a crisis.
Capital is required by banks to absorb unexpected losses that arise during the normal course of the bank’s operations. The Basel III framework tightens capital requirements by limiting the type of capital that a bank may include in its different capital tiers and structures.
A bank’s capital structure consists of several tiers. These include:
- Tier 1 Capital: Known as going concern or core capital, Tier 1 is used to fund a financial institution's business activities. It includes Common Equity Tier 1 (CET1) capital and Additional Tier 1 (AT1) capital.
- Tier 2 Capital: This is often called gone concern or supplementary capital. This category is made up of things like hybrid capital instruments and subordinated term debt.
- Tier 3 Capital: This type of capital includes market risk, commodities risk, and foreign currency risk and is the lowest quality of the three.
Common Equity Tier 1 is "the highest quality of regulatory capital, as it absorbs losses immediately when they occur," according to the Bank of International Settlements. A bank's Tier 1 capital must include a minimum ratio of 4.5% of CET1 to its RWAs.
CET1 is a measure of bank solvency that gauges a bank’s capital strength.
A bank’s capital structure consists of Lower Tier 2, Upper Tier 1, AT1, and CET1. CET1 is at the bottom of the capital structure, which means that any losses incurred are first deducted from this tier in the event of a crisis. If the deduction results in the CET1 ratio dropping below its regulatory minimum, the bank must build its capital ratio back to the required level or risk being overtaken or shut down by regulators.
During the rebuilding phase, regulators may prevent the bank from paying dividends or employee bonuses. In the case of insolvency, the equity holders bear the losses first followed by the hybrid and convertible bondholders and then Tier 2 capital.
The European Banking Authority conducts stress tests using the CET1 ratio from time to time to understand how much capital banks would have left in the adverse event of a financial crisis. The results of these tests have shown that most banks would be able to survive a crisis.
Calculating Common Equity Tier 1 (CET1) Capital
Tier 1 capital is calculated as Common Equity Tier 1 capital plus Additional Tier 1 capital. CET1 comprises a bank’s core capital and includes common shares, stock surpluses resulting from the issue of common shares, retained earnings, common shares issued by subsidiaries and held by third parties, and accumulated other comprehensive income (AOCI).
Additional Tier 1 capital is defined as instruments that are not common equity but are eligible for inclusion in this tier. An example of AT1 capital is a contingent convertible or hybrid security, which has a perpetual term and can be converted into equity when a trigger event occurs. An event that causes a security to be converted to equity occurs when CET1 capital falls below a certain threshold.
This measure is better captured by the CET1 ratio, which measures a bank’s capital against its assets. Because not all assets have the same risk, the assets acquired by a bank are weighted based on the credit risk and market risk that each asset presents.
Common Equity Tier 1 Ratio = Common Equity Tier 1 Capital ÷ Risk-Weighted Assets
For example, a government bond may be characterized as a "no-risk asset" and given a zero percent risk weighting. On the other hand, a subprime mortgage may be classified as a high-risk asset and weighted 65%. According to Basel III capital and liquidity rules, all banks must have a minimum CET1 to RWAs ratio of 4.5%.
How Are Tier 1 Capital and CET1 Capital Different?
CET1 capital is one component of total Tier 1 capital. The other is known as additional Tier 1 capital (AT1). AT1 + CET1 = Tier 1 capital.
What Is the Minimum Tier 1 Capital a Bank Can Have?
The Basel Accords spelled out the minimum capital requirements for banks. They must maintain a minimum capital ratio of 8%, of which 6% must be Tier 1 capital.
What Does a Low CET1 Ratio Mean?
A low CET1 ratio implies an insufficient level of Tier 1 capital. In such a case, a bank may not be able to absorb a financial shock and may need to be bailed out quickly in the event of a financial crisis.
Correction—Nov. 16, 2022: A previous version of this article misstated that Eurozone banks must maintain a minimum CET1 ratio of 15.1% of risk-weighted assets.