Tier classification

Tier classification refers to a system used primarily within financial regulation to categorize different types of regulatory capital held by financial institutions, especially banks. This classification helps regulators assess a bank's ability to absorb losses and maintain capital adequacy. The hierarchy typically distinguishes between higher-quality, loss-absorbing capital and other forms of capital that offer less protection against financial distress. The most well-known application of tier classification is within the Basel Accords, an international framework for bank supervision.

History and Origin

The concept of tier classification for bank capital emerged from the international effort to strengthen the banking system and prevent financial crises. Following disturbances in international currency and banking markets, such as the failure of Bankhaus Herstatt in 1974, the Basel Committee on Banking Supervision (BCBS) was established in Basel, Switzerland, under the auspices of the Bank for International Settlements in late 1974⁸.

The first major framework, Basel I, published in 1988, introduced a system of minimum capital requirements. It defined two main tiers of capital: Tier 1 and Tier 2. Tier 1 capital represented the highest quality, most loss-absorbing capital, while Tier 2 capital comprised supplementary capital components. This tier classification system was designed to enhance the financial stability of the international banking system by establishing consistent standards globally and mitigating competitive inequalities among banks⁷. Subsequent revisions, including Basel II and Basel III, refined and expanded upon this initial tier classification, introducing more granular categories and stricter definitions to address evolving risks and lessons learned from events like the 2008 financial crisis⁶.

Key Takeaways

• Tier classification is a regulatory tool, primarily for banks, to categorize capital based on its loss-absorbing capacity.
• The most significant framework employing tier classification is the Basel Accords, which defines Common Equity Tier 1 (CET1), Additional Tier 1 (AT1), and Tier 2 capital.
• Higher tiers represent more permanent and loss-absorbing capital, essential for a bank's bank solvency.
• Regulators use tier classifications to set minimum capital ratios, ensuring banks can withstand financial shocks.
• The system aims to promote global financial stability and reduce the likelihood of bank failures.

Formula and Calculation

While "Tier classification" itself is a qualitative categorization, the capital ratios derived from these classifications involve specific calculations. The key ratio is the Capital Adequacy Ratio (CAR), which expresses a bank's capital in relation to its risk-weighted assets (RWA).

The formula for the total capital ratio is:

Within Tier 1 capital, there's a further breakdown:

Where:

• Common Equity Tier 1 (CET1) Capital: Represents the highest quality of equity capital, typically including common shares and retained earnings. This is considered the most reliable form of capital as it can absorb losses without a bank having to cease operations.
• Additional Tier 1 (AT1) Capital: Includes instruments that are perpetual and can be converted to equity or written down if the bank faces financial distress, such as certain types of subordinated debt or preferred shares.
• Tier 2 Capital: Comprises supplementary capital instruments that absorb losses in the event of liquidation, but rank below Tier 1. This can include subordinated debt with an original maturity of at least five years and hybrid capital instruments.
• Risk-Weighted Assets (RWA): A bank's assets weighted according to their riskiness. For instance, a loan to a government may have a lower risk weighting than a loan to a volatile startup.

The Federal Reserve Board publishes individual capital requirements for large banks, which include a minimum Common Equity Tier 1 capital ratio requirement and a stress capital buffer requirement⁵.

Interpreting the Tier Classification

Interpreting tier classification involves understanding the quality and availability of a bank's capital to absorb potential losses. A bank with a higher proportion of Common Equity Tier 1 capital is generally considered more resilient and less likely to face insolvency during periods of economic downturn or unexpected losses. This is because CET1 is readily available to absorb losses without triggering a default or requiring immediate restructuring.

Regulators impose minimum thresholds for each tier, ensuring that banks maintain a robust capital structure. For example, the Basel III framework mandates specific minimum percentages for CET1, Additional Tier 1, and total capital relative to risk-weighted assets. Deviations below these thresholds signal potential financial weakness and can lead to supervisory intervention, restricting a bank's ability to distribute dividends or bonuses. A strong tier classification, therefore, indicates not just regulatory compliance but also a bank's fundamental financial health and its capacity to support lending and other economic activities.

Hypothetical Example

Consider "Alpha Bank," a hypothetical financial institution. Regulators require Alpha Bank to maintain certain minimum capital ratios based on the tier classification system.

Let's assume Alpha Bank has:

• Common Equity Tier 1 (CET1) Capital: $100 billion
• Additional Tier 1 (AT1) Capital: $20 billion
• Tier 2 Capital: $30 billion
• Risk-Weighted Assets (RWA): $1,000 billion

Using the formulas for tier classification and capital ratios:

1. Total Tier 1 Capital:

   $$\text{Tier 1 Capital} = \text{CET1 Capital} + \text{AT1 Capital}$$ $$\text{Tier 1 Capital} = \$100 \text{ billion} + \$20 \text{ billion} = \$120 \text{ billion}$$

2. Total Capital:

   $$\text{Total Capital} = \text{Tier 1 Capital} + \text{Tier 2 Capital}$$ $$\text{Total Capital} = \$120 \text{ billion} + \$30 \text{ billion} = \$150 \text{ billion}$$

3. Capital Ratios:

   • CET1 Capital Ratio: $$\text{CET1 Ratio} = \frac{\text{CET1 Capital}}{\text{RWA}} = \frac{\$100 \text{ billion}}{\$1,000 \text{ billion}} = 10\%$$
   • Tier 1 Capital Ratio: $$\text{Tier 1 Ratio} = \frac{\text{Tier 1 Capital}}{\text{RWA}} = \frac{\$120 \text{ billion}}{\$1,000 \text{ billion}} = 12\%$$
   • Total Capital Ratio: $$\text{Total Capital Ratio} = \frac{\text{Total Capital}}{\text{RWA}} = \frac{\$150 \text{ billion}}{\$1,000 \text{ billion}} = 15\%$$

If the regulatory minimums are, for example, 4.5% for CET1, 6% for Tier 1, and 8% for total capital, Alpha Bank, with ratios of 10%, 12%, and 15% respectively, would be considered well-capitalized under the tier classification system. This demonstrates its strong ability to absorb unexpected losses, reflecting a healthy balance sheet and robust stress testing results.

Practical Applications

Tier classification plays a crucial role in several areas of the financial world:

• Banking Regulation: It forms the foundation of international banking standards, such as the Basel Accords, which dictate the minimum regulatory capital banks must hold to absorb losses. Regulators globally use this system to monitor the financial health and stability of individual banks and the banking system as a whole.
• Risk Management: Banks utilize tier classification internally to manage their capital structure and allocate capital efficiently. By understanding the different qualities of capital, they can optimize their balance sheets to meet regulatory requirements while supporting business growth.
• Investor Confidence: A strong tier classification, particularly high Common Equity Tier 1 ratios, signals a bank's resilience to investors, potentially leading to lower borrowing costs and greater market confidence. Investors and analysts closely scrutinize these ratios when evaluating a bank's investment viability.
• Global Financial Stability Monitoring: International bodies like the International Monetary Fund (IMF) use aggregated capital ratios based on tier classifications to assess systemic risks and publish reports on global financial stability⁴. This provides a macroscopic view of the banking sector's health worldwide.

Limitations and Criticisms

While tier classification provides a standardized framework for assessing bank capital, it faces several limitations and criticisms:

• Complexity and Regulatory Arbitrage: The increasing complexity of the Basel frameworks, with their detailed tier classification rules, can lead to regulatory arbitrage. Banks might structure transactions or assets in ways that minimize their risk-weighted assets and, consequently, their capital requirements, without necessarily reducing actual risk.
• Reliance on Internal Models: Critics argue that allowing banks to use complex internal models to calculate risk-weighted assets can introduce opacity and potential manipulation. These models can sometimes underestimate risks, leading to lower capital requirements than might be prudent.
• Procyclicality: Capital requirements based on risk-weighted assets can be procyclical. In good times, perceived risks are low, leading to lower capital requirements and potentially encouraging more lending. In economic downturns, risks increase, leading to higher capital requirements, which can force banks to deleverage and reduce lending, exacerbating the downturn³.
• Unintended Economic Consequences: Some research suggests that stricter capital requirements, rooted in tier classification, may inadvertently lead to increased risk-taking by borrowers who face higher loan costs from banks. This can potentially shift risk from the banking sector to the broader economy².
• "One-Size-Fits-All" Approach: Despite attempts at customization, the international nature of the Basel Accords' tier classification can sometimes be seen as a "one-size-fits-all" approach, which may not adequately address the unique characteristics and needs of all national banking systems or types of banks, particularly in developing economies¹.

Tier Classification vs. Capital Requirements

While closely related, "tier classification" and "capital requirements" refer to distinct but interconnected concepts in financial regulation.

Tier classification is the method of categorizing a bank's regulatory capital into different levels based on its quality, permanence, and ability to absorb losses. It defines what kind of capital counts towards a bank's financial strength and its hierarchy (e.g., Common Equity Tier 1, Additional Tier 1, Tier 2 capital).

Capital requirements, on the other hand, are the minimum amounts or ratios of capital that regulators mandate banks must hold. These requirements are expressed as percentages of risk-weighted assets and are applied to the various tiers of capital. For example, a regulation might state that a bank must maintain a minimum Common Equity Tier 1 capital ratio of 4.5% and a total capital ratio of 8%.

In essence, tier classification provides the qualitative definitions for the different components of capital, while capital requirements specify the quantitative thresholds that banks must meet using those classified capital components. One defines the types of capital, and the other dictates how much of each type, or total, must be held.

FAQs

What are the main tiers of bank capital?

The main tiers of bank capital, as defined by the Basel Accords, are Common Equity Tier 1 (CET1), Additional Tier 1 (AT1), and Tier 2 capital. CET1 is the highest quality, representing common stock and retained earnings, while AT1 and Tier 2 provide supplementary loss-absorbing capacity.

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

Common Equity Tier 1 (CET1) is considered the highest quality capital because it is the most permanent and readily available form of equity capital. It can absorb losses immediately without triggering a bank's insolvency, providing a robust buffer against financial shocks.

How does tier classification help ensure financial stability?

Tier classification helps ensure financial stability by providing a standardized way for regulators to assess and enforce minimum capital levels. By requiring banks to hold sufficient high-quality capital, the system enhances their resilience to economic downturns and reduces the risk of bank failures, which could otherwise destabilize the broader financial system.

Is tier classification only used for banks?

While tier classification is most prominently used in banking regulation due to its critical role in systemic stability, similar hierarchical categorizations of capital or risk may exist in other financial sectors or regulatory frameworks, adapting the core concept of distinguishing assets or capital based on their quality and loss-absorbing capacity.

What are risk-weighted assets?

Risk-weighted assets (RWA) are a bank's assets that have been adjusted for their associated credit risk. Different types of assets, like cash, government bonds, or corporate loans, are assigned different risk weights, meaning that a bank needs to hold more capital against riskier assets than against less risky ones.