Common equity tier 1 cet1 ratio

What Is Common Equity Tier 1 (CET1) Ratio?

The Common Equity Tier 1 (CET1) ratio is a crucial metric in the realm of bank capital requirements, representing a bank's core equity capital as a percentage of its risk-weighted assets. It is widely regarded as a primary indicator of a bank's financial strength and its capacity to absorb losses. Essentially, the CET1 ratio quantifies the highest quality capital a bank holds, which can readily absorb unexpected losses without requiring the bank to cease operations or seek external assistance. A higher CET1 ratio generally signifies greater resilience to economic shocks and periods of financial distress.

This ratio is a cornerstone of global banking regulation, particularly under the Basel III framework, which mandates minimum capital levels for financial institutions. The components of Common Equity Tier 1 capital primarily include common stock, retained earnings, and other comprehensive income, net of specific deductions. Regulators use the CET1 ratio to assess a bank's stability and to ensure it maintains sufficient regulatory capital to safeguard depositors and the broader financial system.

History and Origin

The concept of Common Equity Tier 1 (CET1) capital emerged as a direct response to the 2007-2008 financial crisis. This global event exposed significant weaknesses in the banking sector's capital frameworks, revealing that many financial institutions lacked sufficient high-quality capital to withstand severe economic shocks. In response, the Basel Committee on Banking Supervision (BCBS), an international body of banking supervisory authorities, developed and introduced the Basel III regulatory framework.³⁰, ³¹

Basel III, published in stages from 2010 onwards, aimed to strengthen global capital and liquidity regulations. A central tenet of these reforms was the emphasis on higher quality and quantity of capital, particularly the introduction of CET1. Prior to Basel III, regulatory capital definitions were less stringent, allowing for a broader range of instruments to count towards a bank's core capital. The new framework defined CET1 narrowly, focusing on the most loss-absorbing forms of capital that could be immediately used to absorb losses as they occurred.²⁸, ²⁹ This shift was designed to enhance banks' resilience, reduce the likelihood of bank failure, and mitigate systemic risks in the financial system.²⁶, ²⁷

Key Takeaways

• The Common Equity Tier 1 (CET1) ratio measures a bank's core equity capital against its risk-weighted assets, indicating its ability to absorb losses.
• It is the highest quality of regulatory capital, designed to absorb losses immediately.²⁵
• The CET1 ratio was introduced as a key component of the Basel III international regulatory framework following the 2007-2008 global financial crisis to enhance bank resilience.²³, ²⁴
• A higher CET1 ratio generally signifies a stronger, more resilient bank that is better equipped to navigate periods of financial instability.
• Regulators impose minimum CET1 ratio requirements, along with additional buffers, to ensure banks maintain adequate capital levels.

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 (RWA).

The formula is expressed as:

Where:

• Common Equity Tier 1 Capital includes a bank's core capital elements such as common stock, retained earnings, and certain other comprehensive income components. It represents the most permanent and loss-absorbing form of a bank's capital.²²
• Risk-Weighted Assets (RWA) are a bank's assets weighted according to their credit risk, market risk, and operational risk. For instance, cash may have a 0% risk weighting, while certain loans might have a 100% or higher weighting. This weighting adjusts the total assets to reflect the potential for losses.²⁰, ²¹

Interpreting the Common Equity Tier 1 (CET1) Ratio

Interpreting the Common Equity Tier 1 (CET1) ratio involves understanding its significance as a measure of a bank's financial stability and its capacity to absorb unexpected losses. A higher CET1 ratio indicates that a bank holds a larger proportion of its most loss-absorbing capital relative to its risk exposures, making it more robust.¹⁹ Conversely, a low CET1 ratio suggests a bank may be less capable of withstanding adverse financial conditions, potentially increasing the risk of bank failure without external support.

Regulatory bodies, such as the Federal Reserve in the United States and the European Central Bank, set minimum capital requirements for the CET1 ratio. For example, under Basel III, the minimum CET1 ratio is 4.5% of risk-weighted assets, often supplemented by a capital conservation buffer of 2.5%, bringing the effective minimum to 7%.¹⁷, ¹⁸ Additionally, systemically important financial institutions may face further surcharges due to their potential impact on global systemic risk if they were to fail.¹⁵, ¹⁶ Analysts and investors closely monitor these ratios as part of their assessment of a bank's overall health and its ability to maintain liquidity and continue lending even in times of stress.

Hypothetical Example

Consider a hypothetical bank, "Evergreen Trust," which aims to maintain a strong Common Equity Tier 1 (CET1) ratio to assure its stakeholders and meet regulatory expectations.

Let's assume Evergreen Trust has the following figures:

• Common Equity Tier 1 Capital: $150 billion
• Risk-Weighted Assets (RWA): $1,500 billion

To calculate its CET1 ratio, Evergreen Trust would apply the formula:

Plugging in the values:

This results in a CET1 ratio of 10%.

If the regulatory minimum CET1 ratio, including all applicable buffers, is 7%, Evergreen Trust's 10% ratio indicates a healthy capital buffer above the required threshold. This suggests that the bank is well-capitalized and has a substantial capacity to absorb potential losses from its risk-weighted assets without jeopardizing its operations or requiring external intervention. This strong position enhances confidence in the bank's ability to navigate periods of economic uncertainty or unexpected financial distress.

Practical Applications

The Common Equity Tier 1 (CET1) ratio is a cornerstone in the practical oversight and analysis of financial institutions, finding applications across several key areas. Primarily, it serves as a critical measure for regulatory bodies to ensure banks maintain sufficient regulatory capital to withstand financial shocks. The Federal Reserve, for example, annually announces individual capital requirements for large banks, which are heavily informed by the results of supervisory stress tests and include a minimum CET1 capital ratio requirement.¹³, ¹⁴ These requirements are designed to ensure that banks can continue to lend to households and businesses even under severe economic downturns.¹²

Beyond regulation, the CET1 ratio is vital for investors and analysts who use it to gauge a bank's financial health and compare its resilience against peers. A robust CET1 ratio can signal a bank's ability to sustain operations, absorb losses, and potentially maintain dividend payments or share buybacks even during adverse market conditions. Furthermore, international bodies like the European Central Bank closely monitor the CET1 ratios of banks under their supervision to ensure adherence to Basel III standards, thereby contributing to broader financial stability across jurisdictions.¹¹

Limitations and Criticisms

Despite its importance, the Common Equity Tier 1 (CET1) ratio is not without limitations and has faced various criticisms. One significant concern is the subjectivity involved in calculating risk-weighted assets. Banks use internal models or standardized approaches to assign risk weights to their assets, which can lead to inconsistencies and potential manipulation, making direct comparisons between institutions challenging.¹⁰ This subjectivity can obscure a bank's true risk profile.

Another critique stems from the complexity of the overall regulatory capital framework. Critics argue that the multitude of ratios and buffers—including the basic CET1 ratio, the leverage ratio, and various capital buffers—creates an overly complicated system that can be difficult to interpret and may not always prevent financial instability. Some suggest simplifying the framework to a single, clear capital metric. Fur⁹thermore, while the CET1 ratio is a crucial measure of capital adequacy, it does not fully account for all potential risks, such as operational risks, reputational risks, or sudden liquidity shortages, which have been factors in past bank failure events. Reg⁸ulatory requirements, including those for CET1, also constantly evolve, requiring banks to continually adjust their capital management strategies.

##⁷ Common Equity Tier 1 (CET1) Ratio vs. Tier 1 Capital Ratio

The Common Equity Tier 1 (CET1) ratio and the Tier 1 capital ratio are both critical measures of a bank's financial strength, but they represent different levels of capital quality and scope. The CET1 ratio specifically focuses on the highest quality, most loss-absorbing capital, primarily consisting of common stock and retained earnings. This capital is considered permanent and can absorb losses immediately when they occur, allowing a bank to continue operating as a "going concern."

In contrast, the Tier 1 capital ratio is a broader measure that includes CET1 capital along with "Additional Tier 1" (AT1) capital. AT1 capital comprises other instruments that provide loss absorption on a going-concern basis but do not meet all the stringent criteria for CET1. Examples of AT1 instruments include certain perpetual preferred shares or contingent convertible bonds that can be written down or converted to equity under specific conditions. The⁶refore, while CET1 is a component of Tier 1 capital, the Tier 1 capital ratio provides a more expansive view of a bank's core capital base, encompassing both the most fundamental and slightly less fundamental, but still high-quality, forms of shareholder equity.

FAQs

What is considered a good CET1 ratio?

A good Common Equity Tier 1 (CET1) ratio generally means a bank exceeds the minimum regulatory capital requirements set by authorities like the Basel Committee and national regulators. While the Basel III minimum is 4.5% of risk-weighted assets, many banks aim for a higher ratio, often around 7% or more (including conservation buffers), to demonstrate strong financial health and resilience to potential shocks.

##⁴, ⁵# Why is the CET1 ratio important?

The CET1 ratio is important because it measures a bank's ability to absorb losses using its highest quality capital. A strong CET1 ratio indicates that a bank can withstand periods of financial distress without external support, thereby protecting depositors, maintaining confidence in the financial system, and supporting lending activities.

##³# How does the CET1 ratio differ from the total capital ratio?

The CET1 ratio focuses specifically on the highest quality equity capital (common stock and retained earnings). The total capital ratio, however, is a broader measure that includes both Tier 1 capital (which itself includes CET1) and Tier 2 capital. Tier 2 capital consists of supplementary capital that can absorb losses in the event of liquidation ("gone concern" capital), such as certain subordinated debt and loan-loss reserves.

Do all banks have to meet the same CET1 ratio requirements?

While there is a standard minimum CET1 ratio for all banks (4.5% under Basel III), specific capital requirements can vary. Larger, globally systemically important banks (G-SIBs) often face additional CET1 surcharges due to their potential impact on global systemic risk. Furthermore, national regulators may impose additional buffers or requirements based on their assessment of local market conditions and individual bank risk profiles.¹, ²