What is the Tier 1 Capital Ratio
The tier 1 capital ratio is the ratio of a bank’s core tier 1 capital – its equity capital and disclosed reserves – to its total risk-weighted assets. It is a key measure of a bank's financial strength that has been adopted as part of the Basel III Accord on bank regulation.
Tier 1 Capital Ratio
BREAKING DOWN Tier 1 Capital Ratio
The tier 1 capital ratio is the basis for the Basel III international capital and liquidity standards devised after the financial crisis, in 2010. The crisis showed that many banks had too little capital to absorb losses or remain liquid, and were funded with too much debt and not enough equity.
To force banks to increase capital buffers, and ensure they can withstand financial distress before they become insolvent, Basel III rules would tighten both tier-1 capital and risk-weighted assets (RWAs). The equity component of tier-1 capital has to have at least 4.5% of RWAs. The tier-1 capital ratio has to be at least 6%. Basel III also introduced a minimum leverage ratio, with Tier-1 capital must be at least 3% of total assets, and more for global systemically important banks that are too big to fail. The Basel III rules have yet to be finalized due to an impasse between the U.S. and Europe.
Calculating a Tier 1 Capital Ratio
The tier 1 capital ratio measures a bank’s core equity capital against its total risk-weighted assets – which include all the assets the bank holds that are systematically weighted for credit risk. For example, a bank’s cash on hand and government securities would receive a weighting of 0%, while its mortgage loans would be assigned a 50% weighting.
Tier 1 capital is core capital and is comprised of a bank's common stock, retained earnings, accumulated other comprehensive income (AOCI), noncumulative perpetual preferred stock and any regulatory adjustments to those accounts.
A bank has $10 billion in common stock and $2 billion in retained earnings. Adding these two values together, the bank has $12 billion in tier 1 capital. After weighing its assets according to risk, the bank has $120 billion in risk-weighted assets. Dividing the $12 billion in tier 1 capital by the $120 billion in risk-weighted assets gives the bank a tier 1 capital ratio of 10%.
For more on Basel III and capital adequacy regulations for banks, read Understanding The Basel III International Regulations.