TIER 1 CAPITAL

Definition

Tier 1 Capital is the core measure of a bank’s financial strength from a regulator’s perspective. It consists primarily of common equity, retained earnings, and certain disclosed reserves. Under the Basel Accords, Tier 1 capital represents the highest-quality capital that can absorb losses while a bank remains a going concern, with its highest-quality component, Common Equity Tier 1 (CET1), being the primary focus for regulators.

Origins

• The term “Tier 1” reflects the highest quality, most reliable form of capital in the regulatory hierarchy.

• Introduced under the Basel I Accord (1988) and refined in Basel II and Basel III to strengthen global banking stability.

• Basel III (2010) further subdivided Tier 1 capital into Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1) instruments.

Usage

• Bank Regulation – Central banks require minimum Tier 1 ratios to reduce systemic risk.

• Investor Analysis – Investors use Tier 1 levels to assess a bank’s solvency.

• Stress Testing – Measures how much capital remains under crisis conditions.

• Mergers & Acquisitions – Regulatory approvals often hinge on capital adequacy.
  
  

Components of Tier 1 Capital

1. Common Equity Tier 1 (CET1):

   • Common shares (ordinary equity)

   • Retained earnings

   • Other comprehensive income
   • Regulatory adjustments (e.g., goodwill deductions)

    

2. Additional Tier 1 (AT1):

   • Regulatory adjustments (e.g., goodwill deductions)
   • Contingent convertible instruments (CoCos)
   • Subordinated debt with loss-absorbing features

    

Key Takeaway

• Core capital buffer for banks to absorb unexpected losses.

• Divided into CET1 (highest quality) and AT1 (hybrid instruments).

• Regulators mandate minimum Tier 1 levels to safeguard stability.

• Strong Tier 1 ratios = higher solvency and market confidence.

Context in Financial Modeling

• Valuation of Banks – Analysts examine Tier 1 to gauge financial health.

• Risk-Weighted Assets (RWA) – Denominator in capital adequacy ratios.

• Stress Testing Models – Test Tier 1 depletion under adverse scenarios.

• Cost of Capital (WACC) – Banks with weak Tier 1 often face higher funding costs.
  
  

Nuances & Complexities

• Model risk – Stress tests rely on assumptions and scenarios, which may miss unknown risks.

• Pro-cyclicality – Harsh stress scenarios during downturns may restrict lending.

• Global differences – Standards vary across jurisdictions.

• Black swan events – Some risks (e.g., COVID-19) were underestimated before occurring.
  
  

Mathematical Formulas

Tier 1 Capital Ratio

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

Basel III Minimum Requirements:

• CET1 ratio ≥ 4.5%

• Tier 1 ratio ≥ 6%

• Total capital ratio (including Tier 2) ≥ 8% + buffers

Related Terms

• Common Equity Tier 1 (CET1)

• Additional Tier 1 (AT1)

• Risk-Weighted Assets (RWA)

• Basel Accords

• Capital Adequacy Ratio (CAR)

• Leverage Ratio
  
  

Real-World Applications

2008 Financial Crisis – Many banks lacked sufficient Tier 1, prompting government bailouts.

European Banks (2014) – ECB imposed stricter CET1 minimums to restore stability.

AT1 Bonds (2023) – Credit Suisse’s AT1 bonds were written down to zero during its forced takeover, highlighting investor risks.

References & Sources

• Market Business News: What is Tier 1 Capital?