Tier 1 capital
Encyclopedia
Tier 1 capital is the core measure of a bank
's financial strength from a regulator
's point of view. 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
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.
Capital
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
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 instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems.
The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses, which are covered by provision
s, reserves
and current year profit
s. In Basel I
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.
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
). Most central banks follow the Basel Committee on Banking Supervision
(BCBS) guidelines in setting formulae for asset risk weights. Assets like cash
and coin
s 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).
As an example, assume a bank with $2 of equity receives a client deposit of $10 and lends out all $10. 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 different conventions for calculating and quoting the Tier 1 capital ratio:
Preferred shares 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.
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
's financial strength from a regulator
Bank regulation
Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. This regulatory structure creates transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things...
's point of view. It is composed of core capital, which consists primarily of common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
and disclosed reserves (or retained earnings
Retained earnings
In accounting, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained and called variously retained losses, accumulated losses or...
), but may also include non-redeemable non-cumulative preferred stock
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
. The Basel Committee
Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance...
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.
Capital
Capital requirement
Capital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...
in this sense is related to, but different from, the accounting concept of shareholders' equity. Both Tier 1 and Tier 2 capital
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...
were first defined in the Basel I
Basel I
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten countries...
capital accord and remained substantially the same in the replacement Basel II accord. Tier 2 capital
Tier 2 capital
Tier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...
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
Regulator (economics)
Economic regulators are usually the agencies established by central government for the control of or intervention in the operation of markets, according to public interest principles and criteria....
, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems.
The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses, which are covered by provision
Provision
Provision may refer to:* Provision , an industrial dance / synthpop band from Houston, Texas, USA* Provision , a term for liability in accounting* Provision , a term for a procurement condition...
s, reserves
Bank reserves
Bank reserves are banks' holdings of deposits in accounts with their central bank , plus currency that is physically held in the bank's vault . The central banks of some nations set minimum reserve requirements...
and current year profit
Profit (accounting)
In accounting, profit can be considered to be the difference between the purchase price and the costs of bringing to market whatever it is that is accounted as an enterprise in terms of the component costs of delivered goods and/or services and any operating or other expenses.-Definition:There are...
s. In Basel I
Basel I
Basel I is the round of deliberations by central bankers from around the world, and in 1988, the Basel Committee in Basel, Switzerland, published a set of minimal capital requirements for banks. This is also known as the 1988 Basel Accord, and was enforced by law in the Group of Ten countries...
agreement, Tier 1 capital is a minimum of % ownership equity
Equity (finance)
In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
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 to its total risk-weighted assetRisk-weighted asset
Risk-weighted asset 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 for a financial institution...
s (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
according to a formula determined by the Regulator (usually the country's central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
). Most central banks follow the Basel Committee on Banking Supervision
Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance...
(BCBS) guidelines in setting formulae for asset risk weights. Assets like cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
and coin
Coin
A coin is a piece of hard material that is standardized in weight, is produced in large quantities in order to facilitate trade, and primarily can be used as a legal tender token for commerce in the designated country, region, or territory....
s 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).
As an example, assume a bank with $2 of equity receives a client deposit of $10 and lends out all $10. 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 different conventions for calculating and quoting the Tier 1 capital ratio:
- Tier 1 common capital ratio or
- Tier 1 total capital ratio
Preferred shares 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.
See also
- Tier 2 capitalTier 2 capitalTier 2 capital, or supplementary capital, include a number of important and legitimate constituents of a bank's capital base . These forms of banking capital were largely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord...
- Capital requirementCapital requirementCapital requirement refers to -The standardized requirements in place for banks and other depository institutions, which determines how much capital is required to be held for a certain level of assets through regulatory agencies such as the Bank for International Settlements, Federal Deposit...
and reserve requirementReserve requirementThe reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes... - Basel Accords
- Bank stress testsBank stress testsBank stress tests can mean:* Supervisory Capital Assessment Program in the United States of America* 2010 European Union banking stress test exercise...
- Basel Committee on Banking SupervisionBasel Committee on Banking SupervisionThe Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance...
- Bank for International SettlementsBank for International SettlementsThe Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...