Common equity tier 1

What Is Common Equity Tier 1?

Common Equity Tier 1 (CET1) represents a bank's highest quality of regulatory capital, primarily composed of common stock and retained earnings. Within the broader field of financial regulation, CET1 is crucial because it serves as the most reliable buffer to absorb losses without triggering bank insolvency, thereby protecting depositors and ensuring the stability of the financial system. It is a core component of a bank's capital structure and is considered "going concern" capital, meaning it can absorb losses while the bank continues to operate.

History and Origin

The concept of Common Equity Tier 1 gained prominence as a direct response to weaknesses exposed during the 2007–2008 financial crisis. Prior to this period, definitions of bank capital varied widely across jurisdictions, and existing capital requirements were insufficient to absorb unexpected losses during a severe economic downturn. To address these issues, the Basel Committee on Banking Supervision (BCBS) — a global standard-setter for banking regulation housed at the Bank for International Settlements (BIS) — developed a comprehensive set of reforms known as Basel III.

Intr¹²oduced in December 2010, Basel III aimed to strengthen the quality and quantity of bank capital, improve risk management, and enhance bank transparency. A key pillar of these reforms was the explicit definition and heightened requirements for Common Equity Tier 1. The framework tightened capital requirements by standardizing what could be included in CET1, ensuring that it consisted predominantly of instruments that could absorb losses immediately. This shift sought to prevent a repeat of the crisis, where taxpayer money was frequently used for bank bailouts.

K¹¹ey Takeaways

• Common Equity Tier 1 (CET1) is the highest quality of a bank's regulatory capital, primarily comprising common stock and retained earnings.
• It serves as the primary buffer to absorb losses, allowing a bank to continue operating even under financial stress.
• The CET1 ratio, calculated as CET1 capital divided by risk-weighted assets, is a key metric for assessing a bank's financial strength.
• Regulatory bodies, such as the Federal Reserve, set minimum CET1 ratio requirements to ensure the stability of individual banks and the broader financial system.
• Maintaining adequate Common Equity Tier 1 is crucial for banks to meet regulatory standards, gain market confidence, and support lending activities.

Formula and Calculation

The Common Equity Tier 1 (CET1) ratio is a critical measure of a bank's financial health and its ability to absorb losses. It is calculated by dividing a bank's Common Equity Tier 1 capital by its risk-weighted assets (RWAs).

The formula is expressed as:

Where:

• Common Equity Tier 1 Capital includes core capital elements such as common shares, stock surplus, retained earnings, and accumulated other comprehensive income, less certain regulatory adjustments like goodwill and intangible assets.
• Risk-Weighted Assets (RWAs) represent a bank's assets weighted according to their credit risk. For example, cash may have a 0% risk weight, while a mortgage loan might have a higher risk weight, such as 50% or 100%, reflecting its higher inherent risk. This calculation allows for a standardized assessment of a bank's capital relative to its risk exposures.

Interpreting the Common Equity Tier 1 Ratio

Interpreting the Common Equity Tier 1 (CET1) ratio involves understanding its significance in assessing a bank's resilience. A higher CET1 ratio generally indicates a stronger capital adequacy position, meaning the bank has a larger buffer of high-quality capital to absorb potential losses from its operations, investments, or economic downturns. This strengthens a bank's liquidity and its capacity to withstand adverse financial shocks.

Regulators establish minimum CET1 ratio requirements to ensure banks maintain sufficient capital. For instance, under the Basel III framework, banks must maintain a minimum CET1 ratio of 4.5% of their risk-weighted assets, often supplemented by additional buffers like a capital conservation buffer and, for systemically important banks, a global systemically important bank (G-SIB) surcharge. These additional buffers mean that the effective minimum Common Equity Tier 1 ratio for many large banks is significantly higher than 4.5%. Furthermore, regulatory stress tests are conducted regularly by authorities like the Federal Reserve to evaluate how banks' CET1 ratios would fare under various hypothetical adverse economic scenarios.

Hypothetical Example

Consider a hypothetical bank, "Evergreen Trust," that needs to assess its Common Equity Tier 1 (CET1) ratio at the end of a fiscal quarter.

Let's assume the following:

• Evergreen Trust's total Common Equity Tier 1 Capital (which includes its equity from common shares and retained earnings, minus deductions) is $15 billion.
• Its total Risk-Weighted Assets (RWAs), calculated by applying risk weights to all assets on its balance sheet (e.g., loans, investments, cash), amount to $120 billion.

Using the formula for the CET1 ratio:

So, Evergreen Trust's Common Equity Tier 1 ratio is 0.125, or 12.5%. If the regulatory minimum CET1 ratio, including buffers, is, for example, 10.5%, then Evergreen Trust's 12.5% ratio indicates that it is well above the required threshold, suggesting a strong capital position.

Practical Applications

Common Equity Tier 1 ratios are a cornerstone of modern banking supervision and financial analysis. They provide a critical indicator of a bank's financial strength and its capacity to absorb unexpected losses. Regulators use CET1 ratios to set minimum capital requirements for banks, which can vary based on the bank's size, complexity, and systemic importance. For instance, the Federal Reserve regularly announces individual capital requirements for large banks, composed of a minimum CET1 ratio, a stress capital buffer, and potentially a G-SIB surcharge. In August 2024, the Federal Reserve released its final individual capital requirements, detailing the CET1 ratios mandated for various large banks.

Anal¹⁰ysts and investors closely monitor CET1 ratios to evaluate a bank's safety and soundness. A robust CET1 ratio can signal a bank's ability to weather economic downturns, maintain lending capacity, and potentially continue shareholder distributions like dividend payments or share buyback programs. Conversely, a declining CET1 ratio might prompt concerns about a bank's risk exposure or profitability, leading to increased scrutiny from market participants and regulators. For example, in July 2025, ING Group's common equity Tier 1 ratio dipped following a large share buyback and dividend payments, highlighting how such actions can impact capital levels. Simil⁹arly, UBS has been reportedly exploring contingency plans due to proposed new capital rules that could significantly increase its Common Equity Tier 1 capital ratio, affecting shareholder payouts and growth prospects. The B⁸ank for International Settlements (BIS) consistently monitors the CET1 ratios of global banks, reporting "largely stable" capital ratios for the world's largest banks, indicating their continued adherence to Basel III standards.

L⁷imitations and Criticisms

While Common Equity Tier 1 (CET1) is a vital measure of bank stability, it is not without limitations or criticisms. One primary critique centers on the complexity of calculating risk-weighted assets, the denominator in the CET1 ratio. The models used by banks to determine risk weights can be intricate and opaque, leading to variations in reported risk exposures even for similar assets across different institutions. This complexity can make like-for-like comparisons difficult and may allow banks some discretion in how they measure their risk, potentially masking true exposures.

Some⁶ critics argue that an overreliance on risk-weighted assets can create opportunities for regulatory arbitrage, where banks might adjust their portfolios to reduce reported risk without necessarily reducing actual risk. Additionally, the focus on capital ratios, including CET1, may not fully capture other critical aspects of financial health, such as a bank's liquidity position or its operational risks. There is also an ongoing debate regarding the optimal level of bank capital, with some arguing that excessively high capital requirements could constrain bank lending and economic growth, while others contend that higher capital levels are essential for long-term financial stability. The C⁵ato Institute, for instance, has published critiques advocating for a simplification of bank capital rules, arguing that the existing framework is overly complex and includes redundant measures that add little marginal benefit to basic capital and liquidity rules.

C⁴ommon Equity Tier 1 vs. Additional Tier 1 Capital

Common Equity Tier 1 (CET1) and Additional Tier 1 capital (AT1) are both components of a bank's Tier 1 capital, designed to absorb losses. The key distinction lies in their quality and immediate loss-absorbing capacity. CET1 is considered the highest quality of regulatory capital because it consists primarily of common stock and retained earnings, which absorb losses immediately as they occur without triggering any events that might compromise the bank's ongoing operations. This direct and immediate loss absorption makes CET1 the most reliable buffer against financial distress.

In contrast, Additional Tier 1 capital comprises instruments that do not meet all the stringent criteria for CET1 but can still absorb losses on a "going concern" basis. These typically include non-cumulative perpetual preferred stock or contingent convertible bonds (CoCos), which can be written down or converted to equity under pre-specified conditions (e.g., if the bank's capital falls below a certain threshold). While AT1 instruments provide significant loss absorption, their mechanisms for doing so are not as immediate or unconditional as those of CET1, making CET1 the foundational and most robust component of a bank's capital base.

FAQs

What is the minimum CET1 ratio required by regulators?

Under the Basel III framework, banks are generally required to maintain a minimum Common Equity Tier 1 (CET1) ratio of 4.5% of their risk-weighted assets. However, this is a baseline. Additional capital buffers, such as the capital conservation buffer (2.5%) and potential surcharges for global systemically important banks (G-SIBs), mean that the effective minimum CET1 ratio for many banks is typically higher, often 7% or more.

³Why is Common Equity Tier 1 considered the highest quality capital?

Common Equity Tier 1 is deemed the highest quality because it is composed of permanent and unconditional loss-absorbing instruments, primarily common shares and retained earnings. These components can absorb losses immediately, even while a bank continues its operations, without requiring any specific trigger events or external actions. This direct and inherent ability to absorb losses protects the bank from insolvency and ensures its ongoing viability.

²How do stress tests relate to Common Equity Tier 1?

Stress tests are supervisory exercises conducted by regulatory bodies (like the Federal Reserve in the U.S.) to assess a bank's ability to withstand severe economic downturns. These tests project how a bank's Common Equity Tier 1 (CET1) capital and other financial metrics would perform under hypothetical adverse scenarios, such as a severe recession or market shock. The results help regulators determine if financial institutions have sufficient capital to absorb losses and continue lending even in stressful conditions, thereby informing individual bank capital requirements.¹