What Is Common Equity Tier 1 (CET1)?
Common Equity Tier 1 (CET1) is a component of Tier 1 capital that is mostly common stock held by a bank or other financial institution. It is a capital measure introduced in 2014 as a precautionary means to protect the economy from a financial crisis. It is expected that all banks should meet the minimum required CET1 ratio of 4.5% by 2019.
- Common equity Tier 1 covers the obvious of equities a bank holds such as cash, stock, etc.
- 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)
Following the 2008 financial crisis, the Basel Committee formulated a reformed set of international standards to review and monitor banks' capital adequacy. These standards, 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 the 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 Tier 2 capital, Tier 1 capital, and common equity Tier 1 capital.
Calculating Tier 1 Capital
Tier 1 capital is calculated as CET1 capital plus additional Tier 1 capital (AT1). Common equity Tier 1 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.
CET1 is a measure of bank solvency that gauges a bank’s capital strength.
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.
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 risk-weighted assets (RWA) ratio of 4.5%.
Common Equity Tier 1 Ratio = Common Equity Tier 1 Capital / Risk-Weighted Assets
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.
In 2016, the European Banking Authority conducted stress tests using the CET1 ratio to understand how much capital banks would have left in the adverse event of a financial crisis. The tests were done during a troubling period when many banks in the Eurozone were struggling with huge amounts of nonperforming loans (NPL) and declining stock prices. The result of the test showed that most banks would be able to survive a crisis in 2016.