Common equity tier 1 cet1

What Is Common Equity Tier 1 (CET1)?

Common Equity Tier 1 (CET1) is the highest quality and most reliable form of a bank's regulatory capital, primarily composed of a bank's common stock and retained earnings. As a core component of Tier 1 capital, CET1 represents the capital that can most effectively absorb losses without a bank being required to cease operations. It is a critical measure within banking regulation, falling under the broader category of financial stability, designed to ensure that financial institutions have sufficient financial buffers to withstand unexpected financial shocks. The Common Equity Tier 1 ratio, which compares CET1 to a bank's risk-weighted assets, is a key indicator of a bank's financial strength and its ability to absorb potential losses.

History and Origin

The concept of Common Equity Tier 1 (CET1) gained prominence in the aftermath of the 2008 financial crisis. Prior to this period, international banking regulations, primarily guided by Basel I and Basel II accords, had capital requirements in place, but their definitions of capital were broader and proved insufficient to absorb the massive losses experienced during the crisis. The inadequacy of existing capital buffers prompted global banking regulators to seek more stringent and clearly defined capital standards.¹¹

This led to the development of Basel III, an international regulatory framework introduced by the Basel Committee on Banking Supervision (BCBS) in 2009. Basel III explicitly introduced Common Equity Tier 1 as a new, narrower category of capital, mandating higher minimum ratios and stricter criteria for what could be included. The aim was to ensure that banks held a greater proportion of capital that could genuinely absorb losses at the first sign of financial distress. The implementation of Basel III and its CET1 requirements began phasing in for banks globally starting in 2014, with full implementation generally by 2019.¹⁰

Key Takeaways

• Common Equity Tier 1 (CET1) represents a bank's highest quality capital, designed to absorb losses efficiently.
• It primarily consists of common stock and retained earnings.
• The CET1 ratio is a key metric for assessing a bank's financial strength and resilience.
• Basel III introduced and enhanced CET1 requirements to improve global banking sector stability after the 2008 financial crisis.
• Regulatory bodies like the Federal Reserve monitor and set minimum CET1 ratio requirements for banks.

Formula and Calculation

The Common Equity Tier 1 (CET1) ratio is calculated by dividing a bank's Common Equity Tier 1 capital by its total risk-weighted assets.

The formula is as follows:

Where:

• Common Equity Tier 1 (CET1): This includes common stock, retained earnings, and certain other disclosed reserves, after specific regulatory adjustments and deductions. It represents the most loss-absorbing form of capital.
• Risk-Weighted Assets (RWA): This is the sum of a bank's assets, weighted according to their inherent credit risk, operational risk, and market risk. For example, cash may have a 0% risk weighting, while certain loans might have a 100% risk weighting.

For instance, if a bank has $10 billion in Common Equity Tier 1 capital and $100 billion in risk-weighted assets, its CET1 ratio would be 10%.

Interpreting the Common Equity Tier 1 (CET1) Ratio

Interpreting the Common Equity Tier 1 (CET1) ratio involves understanding its role as a key measure of a bank's resilience and its adherence to capital requirements. A higher CET1 ratio generally indicates that a bank is better capitalized and, therefore, more capable of absorbing unexpected losses from its operations without becoming insolvent or requiring external intervention. This is crucial for maintaining public confidence and overall financial stability.

Regulators, such as the Federal Reserve, establish minimum CET1 ratio requirements. Under Basel III, the minimum CET1 ratio is 4.5% of risk-weighted assets, with additional buffers like the capital conservation buffer, bringing the effective minimum higher for many institutions.⁹ For large banks, these requirements can be further increased by a stress capital buffer derived from supervisory stress tests and, for global systemically important banks (G-SIBs), an additional surcharge.⁸ A bank operating significantly above these minimums is generally viewed as robust, whereas a bank approaching or falling below the minimum thresholds may face regulatory scrutiny, restrictions on dividend payments, or limits on executive bonuses.

Hypothetical Example

Consider "Horizon Bank," a hypothetical financial institution.
Horizon Bank's balance sheet data for its regulatory capital calculation is as follows:

• Common Stock: $5,000 million
• Retained Earnings: $3,000 million
• Goodwill (deduction): $500 million
• Deferred Tax Assets (deduction): $200 million
• Total Risk-Weighted Assets (RWA): $80,000 million

First, calculate Horizon Bank's Common Equity Tier 1 (CET1) capital:

CET1 = (Common Stock + Retained Earnings) - (Goodwill + Deferred Tax Assets)
CET1 = ($5,000 \text{ million} + $3,000 \text{ million}) - ($500 \text{ million} + $200 \text{ million})
CET1 = $8,000 \text{ million} - $700 \text{ million}
CET1 = $7,300 \text{ million}

Next, calculate the CET1 ratio:

In this example, Horizon Bank has a CET1 ratio of approximately 9.125%. This ratio would then be compared against the minimum capital requirements set by relevant financial regulators to determine its capital adequacy.

Practical Applications

Common Equity Tier 1 (CET1) and its associated ratio have several practical applications across the financial industry:

• Regulatory Compliance: Banks must adhere to minimum CET1 ratio requirements set by national and international regulatory bodies, such as the Office of the Comptroller of the Currency (OCC) and the Federal Reserve in the U.S.⁷ Failure to meet these thresholds can result in penalties, operational restrictions, and mandatory capital-raising efforts. The Federal Reserve regularly assesses the aggregate CET1 capital ratio across the banking system to monitor overall health.⁶
• Investor Confidence and Credit Ratings: A strong CET1 ratio signals financial health and resilience, which can boost investor confidence and lead to higher credit ratings for a bank. This can lower a bank's borrowing costs and improve its access to capital markets. Conversely, a weakening CET1 ratio can trigger concerns among investors and rating agencies.
• Risk Management: The CET1 ratio serves as an internal risk management tool, allowing banks to assess their capital adequacy relative to the risks they undertake. By allocating capital based on risk-weighted assets, banks can ensure they hold enough capital to cover potential losses from various exposures, including credit risk.
• Strategic Planning and Growth: Banks with robust CET1 ratios have greater flexibility for strategic initiatives, such as expanding lending activities, pursuing mergers and acquisitions, or increasing shareholder distributions. For example, recent proposals in Switzerland suggest increasing CET1 capital requirements for large banks like UBS, which could impact their strategy and shareholder payouts.⁵
• International Standards: CET1 is a key component of the Basel III framework, which aims to create a globally consistent standard for bank capital. This consistency helps to foster a level playing field among international banks and reduces the risk of regulatory arbitrage.

Limitations and Criticisms

Despite its importance, Common Equity Tier 1 (CET1) and the framework surrounding it have faced certain limitations and criticisms. One primary critique centers on the complexity of calculating risk-weighted assets. The varying methodologies for assigning risk weights to different asset classes can lead to inconsistencies and potential loopholes, where banks might optimize their portfolios to reduce reported RWA rather than genuinely reducing risk. This can obscure the true underlying risk exposure.⁴

Another area of concern is that while higher capital requirements are intended to make banks safer, some critics argue that they can constrain economic growth by limiting a bank's capacity for lending.³ The banking industry, for instance, has at times lobbied against stricter capital rules, arguing that they can hinder their ability to provide loans and participate in financial markets, particularly regarding holdings of low-risk assets like U.S. Treasuries.²

Furthermore, the emphasis on CET1, while providing a strong buffer, does not fully eliminate all forms of systemic risk. Financial innovations and interconnectedness can create new vulnerabilities that even high levels of CET1 might not fully address. Critics also argue that the regulatory response, such as the Dodd-Frank Act following the 2008 financial crisis, while introducing measures like the Volcker Rule to curb speculative activities, might still leave gaps. Some advocacy groups argue that certain proposals by regulators to lower leverage ratio-based capital requirements could introduce greater risks to financial stability.¹

Common Equity Tier 1 (CET1) vs. Tier 1 Capital

Common Equity Tier 1 (CET1) and Tier 1 capital are both crucial measures of a bank's financial strength, but they are not interchangeable. CET1 is a component of Tier 1 capital, representing its highest quality and most loss-absorbing elements.

Common Equity Tier 1 (CET1) primarily includes a bank's common stock and retained earnings, along with certain other components that are fully available to absorb losses without requiring a bank to cease operations. It is the purest form of a bank's core capital.

Tier 1 Capital is a broader category that encompasses CET1 plus "Additional Tier 1" (AT1) capital. AT1 capital includes instruments like perpetual non-cumulative preferred stock that, while designed to absorb losses, do so under slightly different conditions than common equity. These instruments typically have no maturity date and their dividends can be canceled at any time, but they do not confer ownership rights like common stock.

The confusion often arises because both are considered core capital. However, CET1 represents the absolute bedrock of a bank's financial resilience, while Tier 1 capital offers a slightly wider definition of a bank's permanent, non-redeemable capital base. Regulators impose separate minimum ratio requirements for both CET1 and Tier 1 capital, with the CET1 ratio typically being the most stringent.

FAQs

What is the primary purpose of Common Equity Tier 1 (CET1)?

The primary purpose of Common Equity Tier 1 (CET1) is to provide banks with a robust buffer of high-quality capital that can absorb unexpected losses, particularly during times of financial distress. This helps ensure the bank's solvency and contributes to overall financial stability.

How does CET1 differ from other types of capital?

CET1 represents the most loss-absorbing form of a bank's capital, mainly comprising common stock and retained earnings. Other types of capital, such as Additional Tier 1 and Tier 2 capital, include instruments that are less capable of absorbing losses or are subject to different conditions, like subordinated debt.

Why did regulators introduce stricter CET1 requirements?

Regulators introduced stricter CET1 requirements primarily in response to the 2008 financial crisis. The crisis revealed that banks' existing capital buffers were often insufficient to absorb losses, leading to widespread instability. The Basel III framework, which implemented these stricter rules, aimed to enhance the banking sector's resilience.

What happens if a bank's CET1 ratio falls below the minimum requirement?

If a bank's CET1 ratio falls below the minimum capital requirements, regulators can impose restrictions. These may include limitations on dividend payments, share buybacks, and discretionary bonus payments to executive officers. Continued non-compliance could lead to more severe supervisory actions.

Is a higher CET1 ratio always better?

While a higher CET1 ratio generally indicates greater financial strength and a stronger ability to absorb losses, there can be trade-offs. Extremely high capital levels might limit a bank's ability to lend or invest, potentially affecting its profitability and, by extension, economic activity. However, from a prudential standpoint, a robust CET1 ratio is considered desirable for stability.