Common equity tier 1 capital

What Is Common Equity Tier 1 Capital?

Common equity tier 1 capital (CET1) represents the highest quality of regulatory capital held by a bank, serving as the primary buffer against unexpected losses. As a crucial component of Bank Capital Regulation, CET1 includes a bank's most readily available and loss-absorbing financial resources. It primarily comprises common stock and retained earnings, net of certain deductions like goodwill and other intangible assets. This core capital is vital for a bank's solvency, indicating its capacity to absorb significant financial shocks without risking bank failures. The stability provided by robust common equity tier 1 capital levels is fundamental to maintaining public confidence and overall financial system resilience.

History and Origin

The concept of bank capital requirements has evolved over centuries, with early regulations often simply mandating a minimum absolute level of capital for banks to begin operations⁴². However, the understanding and formalization of bank capital gained significant traction in the modern era, particularly with the establishment of international agreements. The first internationally agreed standard for bank capital regulation, known as Basel I, was introduced in 1988 by the Basel Committee on Banking Supervision (BCBS)⁴¹. This accord brought in the concept of risk-weighted assets (RWA), distinguishing between assets based on their inherent credit risk and requiring capital accordingly⁴⁰.

Following the global financial crisis of 2007-2009, severe weaknesses in the quality and consistency of banks' capital bases were exposed³⁹. In response, the BCBS developed Basel III, a comprehensive set of reforms published in 2010 and subsequently revised³⁸. A central element of Basel III was the strengthening of the quality of bank regulatory capital, placing a greater focus on going-concern loss-absorbing capital in the form of common equity tier 1 capital³⁷. This move aimed to ensure banks held sufficient high-quality capital that could absorb losses immediately as they occurred, enhancing transparency and restoring public confidence in capital ratios³⁶. In the United States, the Dodd-Frank Act of 2010 further reinforced stricter capital requirements, notably by excluding hybrid capital instruments like trust preferred securities from Tier 1 capital, thereby emphasizing pure common equity³⁴, ³⁵.

Key Takeaways

• Common equity tier 1 capital (CET1) represents the highest quality of a bank's capital, primarily consisting of common stock and retained earnings.
• It serves as the core measure of a bank's financial strength and its ability to absorb losses without jeopardizing solvency.
• Regulatory frameworks like Basel III mandate minimum CET1 ratios to ensure banks maintain adequate capital buffers against financial shocks.
• The CET1 ratio is calculated by dividing CET1 capital by a bank's total risk-weighted assets.
• Regulators use CET1 in conjunction with stress tests to evaluate a bank's resilience under adverse economic conditions.

Formula and Calculation

The common equity tier 1 capital ratio is a key metric used to assess a bank's financial health. It is calculated as follows:

$\text{CET1 Ratio} = \frac{\text{Common Equity Tier 1 Capital}}{\text{Risk-Weighted Assets (RWA)}}$

Where:

• Common Equity Tier 1 Capital: This includes a bank's common stock, retained earnings, and certain other comprehensive income items, less goodwill and other intangible assets³³.
• Risk-Weighted Assets (RWA): The total value of a bank's assets adjusted for their associated risks. Different assets are assigned different risk weights; for example, cash may have a 0% weight, while mortgage loans could carry weights of 20%, 50%, or 100% depending on their risk profile³².

For instance, if a bank has common equity tier 1 capital of $10 billion and risk-weighted assets of $200 billion, its CET1 ratio would be 5%.

Interpreting the Common Equity Tier 1 Capital

Interpreting the common equity tier 1 capital ratio involves comparing it against regulatory minimums and industry averages. A higher CET1 ratio generally indicates a stronger, more resilient bank that is better positioned to withstand economic downturns and unexpected losses. Regulators, such as the Federal Reserve, set minimum CET1 ratios that banks must maintain³¹. Under Basel III, the minimum CET1 ratio is 4.5% of risk-weighted assets, with an additional 2.5% capital conservation buffer, bringing the effective minimum to 7%²⁹, ³⁰.

Beyond these minimums, banks typically aim to hold CET1 significantly above the required thresholds to provide extra capital buffers and avoid regulatory restrictions on activities like dividend payments or share buybacks²⁷, ²⁸. A declining CET1 ratio could signal deteriorating asset quality or aggressive growth without sufficient capital accumulation, prompting closer scrutiny from supervisors and concerns from investors. Conversely, a robust and stable common equity tier 1 capital ratio reassures markets of a bank's fundamental soundness and its capacity to absorb potential credit risk.

Hypothetical Example

Consider "Horizon Bank," a hypothetical financial institution.

1. Calculate Risk-Weighted Assets (RWA):

   • Cash: $10 billion (0% risk weight) = $0 RWA
   • Government Bonds: $50 billion (10% risk weight) = $5 billion RWA
   • Corporate Loans (low risk): $100 billion (50% risk weight) = $50 billion RWA
   • Corporate Loans (high risk): $40 billion (100% risk weight) = $40 billion RWA
   • Total RWA = $0 + $5 billion + $50 billion + $40 billion = $95 billion

2. Determine Common Equity Tier 1 Capital:

   • Common Stock: $5 billion
   • Retained Earnings: $3 billion
   • Less: Goodwill and Intangible Assets: $1 billion
   • Total Common Equity Tier 1 Capital = $5 billion + $3 billion - $1 billion = $7 billion

3. Calculate the CET1 Ratio:
   $\text{CET1 Ratio} = \frac{\text{\$7 billion}}{\text{\$95 billion}} \approx 0.0737 \text{ or } 7.37\%$

Horizon Bank's common equity tier 1 capital ratio of 7.37% indicates that it meets the minimum Basel III requirement of 4.5% and is above the 7% threshold (4.5% minimum + 2.5% conservation buffer)²⁶. This suggests Horizon Bank has a healthy capital position relative to its risk exposures, contributing to its overall financial stability.

Practical Applications

Common equity tier 1 capital is a cornerstone of global Bank Capital Regulation, appearing in several critical areas of the financial system. It is primarily used by national and international regulators, such as the Basel Committee on Banking Supervision (BCBS) and the Federal Reserve, to set minimum capital requirements for banks²⁵. These requirements aim to ensure that banks have sufficient high-quality capital to absorb losses and maintain stability, thereby mitigating systemic risk within the financial system.

One of the most significant applications is in supervisory stress tests, which assess how large banks would perform under hypothetical adverse economic conditions²³, ²⁴. The results of these stress tests directly inform a bank's common equity tier 1 capital requirements, including the determination of specific capital buffers such as the Stress Capital Buffer (SCB) and the Global Systemically Important Bank (G-SIB) surcharge²¹, ²². The Federal Reserve publishes annual stress test results, indicating how major U.S. banks' CET1 ratios are projected to withstand severe recessions and financial market shocks²⁰. This forward-looking assessment helps regulators and the public understand the resilience of the banking sector. The detailed information on these stress tests can be found on the Federal Reserve Board website.

Furthermore, CET1 is crucial for investors and analysts in evaluating a bank's financial strength and its capacity to sustain operations and distributions, such as dividends, during periods of stress.

Limitations and Criticisms

While common equity tier 1 capital is a vital measure of a bank's resilience, it is not without limitations or criticisms. One primary critique centers on the inherent complexity¹⁹ and potential for variability in the calculation of risk-weighted assets (RWA), which forms the denominator of the CET1 ratio. Despite efforts by frameworks like Basel III to standardize RWA calculations, differences in banks' internal models and national regulatory interpretations can lead to inconsistencies in reported ratios across jurisdictions¹⁷, ¹⁸. This variability can make direct comparisons between banks challenging and potentially obscure true risk exposures.

Another concern is that focusing heavily on common equity tier 1 capital may incentivize banks to reduce their RWA through asset restructuring or by concentrating on assets with lower risk weights, rather than genuinely improving their underlying risk management¹⁵, ¹⁶. There are also ongoing debates about whether the increased regulatory capital requirements, including for CET1, might inadvertently reduce banks' lending capacity, potentially hindering economic growth by raising the cost of credit¹⁴. Some critics also argue that while CET1 provides a buffer against losses, it doesn't fully address all types of financial risk, such as extreme liquidity risk that can arise from sudden market dislocations, which necessitate other regulatory tools like liquidity coverage ratios¹², ¹³.

Common Equity Tier 1 Capital vs. Tier 1 Capital

Common equity tier 1 capital (CET1) and Tier 1 capital are both crucial measures of a bank's financial strength, but they differ in their scope of included components.

The key distinction lies in CET1 representing the purest form of a bank's equity capital. While all CET1 is Tier 1 capital, not all Tier 1 capital is CET1. The Basel III framework specifically elevated the importance of common equity tier 1 capital by requiring it to be the predominant form of Tier 1 capital, reflecting a global push for banks to hold higher quality and more readily available capital to withstand financial distress⁵. This focus aims to reduce reliance on more complex or less loss-absorbing instruments in a crisis.

FAQs

What is the minimum Common Equity Tier 1 capital ratio required?

Under the international Basel III framework, banks are generally required to maintain a minimum common equity tier 1 capital ratio of 4.5% of their risk-weighted assets. Additionally, a 2.5% capital conservation buffer is typically required, bringing the effective minimum to 7%⁴. Larger, globally systemically important banks may face even higher requirements.

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

Common equity tier 1 capital is considered the highest quality because it represents a bank's fundamental equity. It is the first line of defense against losses, as it can absorb them immediately without triggering default or liquidation. This capital is permanent and freely available to cover unexpected financial setbacks, directly supporting the bank's ability to continue operations during periods of stress³.

How do bank stress tests relate to Common Equity Tier 1 capital?

Stress tests are crucial regulatory exercises conducted by authorities like the Federal Reserve to evaluate how a bank's common equity tier 1 capital would hold up under severely adverse economic scenarios². These tests project potential losses and their impact on a bank's CET1 ratio, informing regulators about the bank's resilience and helping set specific capital buffers tailored to each institution's risk profile¹.

Does Common Equity Tier 1 capital include preferred stock?

No, common equity tier 1 capital explicitly excludes preferred stock. While preferred stock can be included in Additional Tier 1 capital (which is part of the broader Tier 1 capital), CET1 is restricted to the purest forms of equity, primarily common stock and retained earnings, net of certain deductions. This narrow definition enhances its quality as a loss-absorbing buffer.