Tier 1 capital is the core measure of a

bank A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Because ...

's financial strength from a regulator's point of view.By definition of

Bank for International Settlements The Bank for International Settlements (BIS) is an international financial institution owned by central banks that "fosters international monetary and financial cooperation and serves as a bank for central banks". The BIS carries out its work thr ...

. It is composed of ''core capital'', which consists primarily of common stock and disclosed reserves (or retained earnings), but may also include non-redeemable non-cumulative preferred stock. The

Basel Committee The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten (economic), Group of Ten (G10) countries in 1974. The committee expanded ...

also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital. This part of the Tier 1 capital will be phased out during the implementation of Basel III.

Capital Capital may refer to: Common uses * Capital city, a municipality of primary status ** List of national capital cities * Capital letter, an upper-case letter Economics and social sciences * Capital (economics), the durable produced goods used f ...

in this sense is related to, but different from, the accounting concept of shareholders' equity. Both Tier 1 and Tier 2 capital were first defined in the

Basel I Basel I is the first Basel Accord. It arose from deliberations by central bankers from major countries during the late 1970s and 1980s. In 1988, the Basel Committee on Banking Supervision (BCBS) in Basel, Switzerland, published a set of minimum ca ...

capital accord and remained substantially the same in the replacement Basel II accord. Tier 2 capital represents "supplementary capital" such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt. Each country's banking regulator, however, has some discretion over how differing

financial instrument Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...

s may count in a capital calculation, because the legal framework varies in different legal systems. The theoretical reason for holding capital is that it should provide protection against unexpected losses. This is not the same as expected losses, which are covered by provisions, reserves and current year

profit Profit may refer to: Business and law * Profit (accounting), the difference between the purchase price and the costs of bringing to market * Profit (economics), normal profit and economic profit * Profit (real property), a nonpossessory intere ...

s. In

agreement, Tier 1 capital is a minimum of % ownership equity but investors generally require a ratio of 10%. Tier 1 capital should be greater than % of the minimum requirement.

Tier 1 capital ratio

The Tier 1 capital ratio is the ratio of a bank's core

equity capital In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth $ ...

to its total

risk-weighted asset Risk-weighted asset (also referred to as RWA) is a bank's assets or off-balance-sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financi ...

s (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by the Regulator (usually the country's

central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central ba ...

). Most central banks follow the

Basel Committee on Banking Supervision The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten (G10) countries in 1974. The committee expanded its membership in 2009 a ...

(BCBS) guidelines in setting formulae for asset risk weights. Assets like

cash In economics, cash is money in the physical form of currency, such as banknotes and coins. In bookkeeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-imm ...

and

currency A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general def ...

usually have zero risk weight, while certain loans have a risk weight at 100% of their face value. The BCBS is a part of the Bank of International Settlements (BIS). Under BCBS guidelines total RWA is not limited to Credit Risk. It contains components for Market Risk (typically based on value at risk (VAR) ) and Operational Risk. The BCBS rules for calculation of the components of total RWA have seen a number of changes following the

Financial crisis of 2007–08 Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...

. As an example, assume a bank with $2 of equity lends out $10 to a client. Assuming that the loan, now a $10 asset on the bank's balance sheet, carries a risk weighting of 90%, the bank now holds risk-weighted assets of $9 ($10 × 90%). Using the original equity of $2, the bank's Tier 1 ratio is calculated to be $2/$9 or 22%. There are two conventions for calculating and quoting the Tier 1 capital ratio: * Tier 1 common capital ratio and * Tier 1 total capital ratio

Preferred shares Preferred stock (also called preferred shares, preference shares, or simply preferreds) is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt inst ...

and non-controlling interests are included in the Tier 1 total capital ratio but not the Tier 1 common ratio. As a result, the common ratio will always be less than or equal to the total capital ratio. In the example above, the two ratios are the same.

Tier 1 capital ratio

See also

Notes

References

External links