Tier 1 capital is the core measure of a

bank A bank is a financial institution that accepts Deposit account, 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 m ...

'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 th ...

. It is composed of ''core capital'', which consists primarily of

common stock Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently outside of the United States. They are known as equity shares or ordinary shares in the UK and other Comm ...

and disclosed reserves (or

retained earnings The retained earnings (also known as plowback) of a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point of time, such as at the end of the reporting period. At the end of that peri ...

), but may also include non-redeemable non-cumulative

preferred stock 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 ...

. 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 (G10) countries in 1974. The committee expanded its membership in 2009 a ...

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 Basel III is the third Basel Accord, a framework that sets international standards for bank capital adequacy, stress testing, and liquidity requirements. Augmenting and superseding parts of the Basel II standards, it was developed in response t ...

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 fo ...

in this sense is related to, but different from, the accounting concept of

shareholders' equity 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 $2 ...

. 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 ...

capital accord and remained substantially the same in the replacement

Basel II accord Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. It is now extended and partially superseded by Basel III. The Basel II Accord was publis ...

. Tier 2 capital represents "supplementary capital" such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and

subordinated debt In finance, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts if a company falls into liquidation or bankruptcy. Such debt is referred to as 'subordi ...

. 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 inter ...

s. In

agreement, Tier 1 capital is a minimum of %

ownership equity 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 $2 ...

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 $2 ...

to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by

credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...

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 centra ...

). 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-im ...

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 ...

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 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 th ...

(BIS). Under BCBS guidelines total RWA is not limited to Credit Risk. It contains components for

Market Risk Market risk is the risk of losses in positions arising from movements in market variables like prices and volatility. There is no unique classification as each classification may refer to different aspects of market risk. Nevertheless, the most ...

(typically based on

value at risk Value at risk (VaR) is a measure of the risk of loss for investments. It estimates how much a set of investments might lose (with a given probability), given normal market conditions, in a set time period such as a day. VaR is typically used by ...

(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 f ...

. 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