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What is the 'Tier 1 Common Capital Ratio'

Tier 1 common capital ratio is a measurement of a bank's core equity capital compared with its total risk-weighted assets that signifies a bank's financial strength. The Tier 1 common capital ratio is utilized by regulators and investors because it shows how well a bank can withstand financial stress and remain solvent. Tier 1 common capital excludes any preferred shares or non-controlling interests when determining the amount of Tier 1 common capital when calculating the ratio.

BREAKING DOWN 'Tier 1 Common Capital Ratio'

The Tier 1 common capital ratio differs from the Tier 1 capital ratio. Tier 1 capital includes the sum of a bank's equity capital, and its disclosed reserves and non-redeemable, non-cumulative preferred stock. Tier 1 common capital, however, excludes all types of preferred stock as well as non-controlling interests. Tier 1 common capital includes the firm's common stock, retained earnings and other comprehensive income.

A firm's risk-weighted assets include all assets that the firm holds that are systematically weighted for credit risk. Central banks typically develop the weighting scale for different asset classes; cash and government securities carry zero risk, while a mortgage loan or car loan would carry more risk. The risk-weighted assets would be assigned an increasing weight according to their credit risk. Cash would have a weight of 0%, while loans of increasing credit risk would carry weights of 20%, 50% or 100%.

Investment Considerations

Regulators use the Tier 1 common capital ratio to grade a firm's capital adequacy as one of the following: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized or critically undercapitalized. A firm must have a Tier 1 common capital ratio of 7% or greater and not pay any dividends or distributions that would affect its capital to be classified as well-capitalized. A firm characterized as a systemically important financial institution (SIFI) is subject to an additional 3% cushion for its Tier 1 common capital ratio, making its threshold to be considered well-capitalized at 10%. Firms not considered well-capitalized are subject to restrictions on paying dividends and share buybacks.

Bank investors pay attention to the Tier 1 common capital ratio because it foreshadows whether a bank has not only the means to pay dividends and buyback shares but also the permission to do so from regulators. The Federal Reserve assesses a bank's Tier 1 common capital ratio during stress tests to discern whether a bank can withstand economic shocks and market volatility.

Tier 1 Common Capital Ratio Calculation

Say a bank has $100 billion of risk-weighted assets after assigning the corresponding weights for its cash, credit lines, mortgages and personal loans. Its Tier 1 common capital includes $4 billion of common stock and $4 billion of retained earnings leading to total Tier 1 common capital of $8 billion. Dividing the Tier 1 common capital of $8 billion by total risk-weighted assets of $100 billion yields a Tier 1 common capital ratio of 8%.

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