Tier 1 capital

What Is Tier 1 Capital?

Tier 1 capital represents a bank's core capital, primarily composed of shareholders' equity and retained earnings. It is considered the highest quality of capital because it is fully available to absorb losses without requiring the bank to cease operations. As a fundamental component of regulatory capital, Tier 1 capital is crucial for a bank's financial stability and its ability to withstand unexpected loan losses or an economic downturn. This category of capital falls under the broader financial category of banking regulation.

Tier 1 capital is often subdivided into Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1) capital. CET1 is the purest form, consisting mainly of common stock and retained earnings. AT1 capital includes other non-common equity instruments that are perpetual and can absorb losses, such as certain types of preferred stock and some hybrid securities. Maintaining adequate Tier 1 capital is a key metric used by regulators to assess a bank's solvency.

History and Origin

The concept of bank capital requirements has evolved significantly, with roots tracing back to early 20th-century proposals for capital-to-deposit ratios. For much of the 20th century, federal regulators in the United States were often reluctant to impose strict minimum capital-to-asset or capital-to-deposit ratios on banks, sometimes allowing market forces to dictate capital levels. However, banking stresses in the 1970s and early 1980s led to a shift in this approach. In 1981, U.S. federal regulators began coordinating on uniform definitions of "primary" and "secondary" capital, and the International Lending Supervision Act of 1983 explicitly authorized regulators to set capital ratios.¹¹,¹⁰

International coordination on capital standards began in the late 1980s, leading to a series of agreements known as the Basel Accords. Basel I, introduced in 1988, formalized risk-weighted capital requirements. However, the global financial crisis of 2007-2009 revealed deficiencies in the existing regulatory frameworks, prompting a comprehensive overhaul. In response, the Basel Committee on Banking Supervision (BCBS) developed Basel III, an internationally agreed-upon set of measures published in 2010. Basel III aimed to strengthen bank regulation, supervision, and risk management globally, significantly increasing the quality and quantity of Tier 1 capital required from banks. The Basel III framework introduced new requirements for Common Equity Tier 1 (CET1) capital and increased the overall Tier 1 capital requirements, reflecting a global commitment to more resilient banking systems.,⁹,⁸,⁷

Key Takeaways

• Tier 1 capital is a bank's core capital, comprising common equity and retained earnings, along with certain perpetual non-cumulative preferred stock and hybrid instruments.
• It is considered the highest quality capital because it can absorb losses without triggering a bank's liquidation.
• Regulatory frameworks like Basel III mandate minimum Tier 1 capital ratios to ensure bank stability and protect depositors.
• Adequate Tier 1 capital enhances public confidence in the banking system and enables banks to continue lending during periods of financial stress.
• The ratio of Tier 1 capital to risk-weighted assets (RWA) is a key metric for assessing a bank's financial strength.

Formula and Calculation

The primary measure involving Tier 1 capital is the Tier 1 Capital Ratio, which assesses a bank's capital strength against its risk-weighted assets.

The formula for the Tier 1 Capital Ratio is:

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

Where:

• Tier 1 Capital = The sum of Common Equity Tier 1 (CET1) capital and Additional Tier 1 (AT1) capital. CET1 primarily includes common shareholders' equity (common stock and retained earnings), while AT1 includes instruments like perpetual non-cumulative preferred stock.
• Risk-Weighted Assets (RWA) = A bank's assets weighted by their credit risk. For instance, cash generally has a 0% risk weighting, while loans to corporations may have higher weightings, reflecting the potential for default. This weighting mechanism aims to account for the varying levels of risk associated with different assets on a bank's balance sheet.

Interpreting Tier 1 Capital

Interpreting Tier 1 capital typically involves evaluating the Tier 1 Capital Ratio. A higher Tier 1 Capital Ratio indicates a stronger capital base and a greater ability for a bank to absorb potential losses, thereby reducing its risk of failure. Regulators set minimum thresholds for this ratio, and exceeding these minimums is generally viewed favorably by investors and analysts. For instance, under Basel III, internationally active banks are required to maintain a minimum CET1 ratio of 4.5% of RWA, and a total Tier 1 capital ratio of 6% of RWA, both subject to additional buffers.,⁶

Banks that maintain robust Tier 1 capital ratios are generally perceived as more resilient during periods of economic volatility. Conversely, a declining Tier 1 capital ratio could signal increasing financial risk and may prompt supervisory intervention. This ratio is a critical indicator of a bank's long-term viability and its capacity to support lending and other financial activities, even during adverse market conditions.

Hypothetical Example

Imagine "DiversiBank," a hypothetical commercial bank.
As of the end of the year, DiversiBank reports the following:

• Common Equity Tier 1 (CET1) Capital: $50 billion
• Additional Tier 1 (AT1) Capital: $10 billion
• Total Risk-Weighted Assets (RWA): $750 billion

To calculate DiversiBank's Tier 1 Capital:
Tier 1 Capital = CET1 Capital + AT1 Capital
Tier 1 Capital = $50 billion + $10 billion = $60 billion

Next, calculate DiversiBank's Tier 1 Capital Ratio:
Tier 1 Capital Ratio = Tier 1 Capital / RWA
Tier 1 Capital Ratio = $60 billion / $750 billion = 0.08 or 8%

In this example, DiversiBank has a Tier 1 Capital Ratio of 8%. This figure can then be compared against regulatory minimums, such as those prescribed by the capital adequacy ratio requirements set by the Basel Accords, and against the ratios of its peers. An 8% ratio indicates a healthy capital position, providing a buffer against unexpected losses and supporting the bank's ongoing operations and lending activities.

Practical Applications

Tier 1 capital serves several critical practical applications in the financial world:

• Regulatory Compliance: Banking regulators worldwide, including the Federal Reserve in the U.S. and the Basel Committee on Banking Supervision, establish minimum Tier 1 capital requirements to ensure the safety and soundness of the banking system. Banks must meet these thresholds to operate, and consistently falling below them can trigger supervisory actions. The Federal Reserve, for example, has also implemented comprehensive capital plan and stress test requirements for large banks to ensure they can maintain sufficient capital under adverse economic conditions.⁵
• Risk Management: By mandating a strong Tier 1 capital base, regulators aim to compel banks to manage their risks more prudently. Higher capital levels mean banks have more of their own funds at risk, discouraging excessive risk-taking and fostering a more disciplined approach to lending and investment decisions. This is particularly relevant in the wake of financial crises, where inadequate capital was a significant contributing factor.⁴
• Investor Confidence: A robust Tier 1 capital ratio is a key indicator for investors assessing the financial health and stability of a bank. Banks with strong Tier 1 ratios are often viewed as more resilient, which can lead to lower funding costs and greater access to capital markets.
• Lending Capacity: Sufficient Tier 1 capital allows banks to expand their lending activities responsibly. With a solid capital foundation, banks can absorb potential losses from new loans without jeopardizing their overall stability, thereby supporting economic growth.

Limitations and Criticisms

Despite its importance, Tier 1 capital and its regulatory framework have limitations and have faced criticisms:

• Complexity and Interpretation: The definition and calculation of Tier 1 capital, particularly the components of Additional Tier 1 (AT1) capital and the nuances of risk-weighted assets, can be complex. This complexity can sometimes make it challenging to compare banks directly or fully understand the true underlying risks.
• Risk Weighting Inaccuracies: The process of risk-weighting assets has been a point of contention. Critics argue that standardized risk weights might not always accurately reflect the true risk profiles of diverse bank assets, potentially leading to undercapitalization of certain risky exposures or overcapitalization of safer ones. This can create opportunities for regulatory arbitrage.
• Procyclicality: Some argue that capital requirements, including Tier 1, can be procyclical, meaning they may exacerbate economic downturns. During a recession, loan losses increase, reducing a bank's capital. To meet ratios, banks might then reduce lending, further tightening credit and deepening the economic contraction.
• Loss-Absorbency of AT1 Instruments: While AT1 instruments are designed to absorb losses, their contractual terms can lead to unexpected outcomes. For example, during the crisis involving Credit Suisse in 2023, approximately $17 billion of the bank's AT1 bonds were controversially written down to zero by the Swiss regulator, while shareholders received some compensation. This decision inverted the traditional hierarchy of creditors and sparked significant debate and legal challenges among bondholders.³,²,¹ This event highlighted concerns about the unpredictability of AT1 bond write-downs in "viability events," even though such provisions are typically embedded in their terms.

Tier 1 Capital vs. Tier 2 Capital

Tier 1 capital and Tier 2 capital are both components of a bank's total regulatory capital, but they differ significantly in quality and loss-absorption capacity.

The primary distinction lies in their ability to absorb losses. Tier 1 capital, particularly Common Equity Tier 1 (CET1), is designed to absorb losses while the bank is still a going concern, meaning it can absorb losses without the bank being forced into liquidation. This allows the bank to continue operating. In contrast, Tier 2 capital, which includes instruments like subordinated debt, provides a lesser degree of permanence and loss absorption. It can absorb losses in the event of liquidation, thus protecting depositors and other senior creditors, but typically cannot absorb losses while the bank remains a going concern without triggering its failure or resolution. Regulators generally require banks to maintain a larger proportion of Tier 1 capital relative to Tier 2 capital.

FAQs

What is the primary purpose of Tier 1 capital?

The primary purpose of Tier 1 capital is to provide a robust buffer against unexpected financial losses, allowing a bank to remain solvent and continue its operations even during periods of significant stress. It ensures that a bank has sufficient capital to absorb losses before affecting depositors or requiring government intervention.

How do regulators use Tier 1 capital?

Regulators use Tier 1 capital to assess a bank's financial strength and stability. They establish minimum Tier 1 capital adequacy ratio requirements that banks must meet to ensure they are adequately capitalized to manage risks and protect the financial system. Falling below these thresholds can trigger supervisory actions and restrictions.

What is the difference between Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1) capital?

Common Equity Tier 1 (CET1) capital is the highest quality and most loss-absorbent form of capital, consisting primarily of common stock and retained earnings. Additional Tier 1 (AT1) capital consists of other instruments, such as certain types of perpetual preferred stock, that can absorb losses but do not qualify as CET1. Both are components of overall Tier 1 capital.

Why is Tier 1 capital important for bank stability?

Tier 1 capital is crucial for bank stability because it acts as the first line of defense against losses. A strong Tier 1 capital base signifies a bank's resilience to adverse economic conditions, reduces the likelihood of bank failures, and fosters confidence among depositors and investors, thereby contributing to overall financial stability.