Tier 1 Capital Ratio

Tier 1 Capital Ratio

Tier 1 Capital Ratio is the ratio of Tier 1 capital (capital that is available for banks on a going concern basis) as a proportion of bank’s risk-weighted assets.  Tier 1 capital includes the bank’s shareholder’s equity, retained earnings, accumulated other comprehensive income, and contingently convertible and perpetual debt instruments of the bank.

Explanation

Tier 1 Capital Ratio

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Formula

Formula

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Components

Tier 1 Capital = Common Equity Tier 1 Capital + Additional Tier 1 Capital

  1. Common Equity Tier 1 (CET1) Capital – CET1 capital is the core equity capital of the bank and includes shareholder’s equity EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.read more, retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more, and accumulated other comprehensive incomeOther Comprehensive IncomeOther comprehensive income refers to income, expenses, revenue, or loss not being realized while preparing the company's financial statements during an accounting period. Thus, it is excluded and shown after the net income.read more of the bank.
  2. Additional Tier 1 (AT1) Capital – AT1 capital includes certain contingently convertible and perpetual debt of the bank since they provide going concern capital to the bank.
CET1 Capital Ratio Formula

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OR

AT1 Capital Ratio Formula

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Tier1 = CET1 + AT1

  • = 4.5% + 1.5%
  • = 6%

Basel III accord focused on building up the core capital of the banksCapital Of The BanksBank Capital, also known as the net worth of the bank is the difference between a bank’s assets and its liabilities and primarily acts as a reserve against unexpected losses.read more. As a result, the norms capped the amount of AT1 capital that can be considered to reckon Tier 1 capital, at 1.5% of the bank’s risk-weighted assets.

Example

Consider an example of a bank determining its risk-weighted assets at $150,000 million. The amount that qualifies as Tier 1 capital after regulator adjustments add up to $10,500 million, with CET1 capital comprising $9,500 million and AT1 capital accountingCapital AccountingThe capital account refers to the general ledger that records the transactions related to owners funds, i.e. their contributions earnings earned by the business till date after reduction of any distributions such as dividends. It is reported in the balance sheet under the equity side as “shareholders’ equity.”read more for the balance of $1,000 million.

This can be calculated as follows:

Example 1

Alternatively,

  • = ($9,500 ÷ $150,000) + ($1,000 ÷ $150,000)
Example 1-1

Ratio = CET1 Ratio + AT1 Ratio

  • = 6.33% + 0.67%
Example 1-2
  • = 7%

Tier 1 Capital vs. Tier 1 Leverage Ratio

Tier 1 Leverage Ratio = Tier 1 Capital / On and Off-Balance SheetOff-Balance SheetOff-balance sheet items are those assets that are not directly owned by the business and therefore do not appear in the basic format of the balance sheet. However, they tend to impact the financials of the company indirectly.read more Exposures.

  • Tier 1 leverage ratio was introduced by the Basel III norms to prevent banks from excessively leveraging their businesses. Basel III prescribes a minimum Tier 1 leverage ratio of 3%.
  • Banks that are considered too big to fail, the failure of which is expected to have an adverse effect on the global economy as a whole, are categorized as Global Systemically Important Banks (G-SIBs). The minimum Tier 1 capital and Tier 1 leverage requirement for G-SIBs is prescribed at a level higher than other banks. The exact regulatory minimum is fixed on a case-to-case basis for each G-SIB separately, taking into account factors such as the size of their bank and their relative importance, its interconnectedness with the economies across jurisdictions, level of infrastructure facilities of the bank, etc.

Conclusion

Basel III norms resulted in the tightening of Tier 1 capital norms and the introduction of the Tier 1 leverage ratio to prevent excessive build-up of leverage and to increase the capacity of the banks’ capital to be able to cushion possible losses from its exposures. A more robust Tier 1 capital ratio indicates the better ability of the bank to be able to absorb losses. Therefore, as a general rule of thumb, the higher the ratio, more particularly the CET1 capital ratio, the better.

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