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Tier 1 capital is the core measure of abank's financial strength from aregulator's point of view.[note 1] It is composed ofcore capital,[1] which consists primarily ofcommon stock and disclosed reserves (orretained earnings),[2] but may also include non-redeemable non-cumulativepreferred stock as well as physical gold held in vaults. TheBasel 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. This part of the Tier 1 capital will be phased out during the implementation ofBasel III.
Capital in this sense is related to, but different from, the accounting concept ofshareholders' equity. Both Tier 1 andTier 2 capital were first defined in theBasel I capital accord and remained substantially the same in the replacementBasel II accord.Tier 2 capital represents "supplementary capital" such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, andsubordinated debt.
Each country's bankingregulator, however, has some discretion over how differingfinancial instruments 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 byprovisions,reserves and current yearprofits. InBasel I agreement, Tier 1 capital is a minimum of 4%ownership equity but investors generally require a ratio of 10%. Tier 1 capital should be greater than 150% of the minimum requirement.[citation needed]
The Tier 1 capital ratio is the ratio of a bank's coreequity capital to its totalrisk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted bycredit risk according to a formula determined by the Regulator (usually the country'scentral bank). Most central banks follow theBasel Committee on Banking Supervision (BCBS) guidelines in setting formulae for asset risk weights. Assets likecash andcurrency usually have zero risk weight, while certain loans have a risk weight at 100% of their face value. The BCBS is a part of theBank of International Settlements (BIS). Under BCBS guidelines total RWA is not limited to Credit Risk. It contains components forMarket Risk (typically based onvalue at risk (VAR) ) andOperational Risk. The BCBS rules for calculation of the components of total RWA have seen a number of changes following the2008 financial crisis.[3]
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:
Preferred shares and non-controlling interests are included in the Tier 1 total capital ratio but not the Tier 1 common ratio.[4] 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.
