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Tier 1 Capital Ratio

Updated on April 26, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Tier 1 Capital Ratio?

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

Tier 1 Capital Ratio

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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 cushion possible losses from its exposures. A more robust Tier 1 capital ratio indicates a better ability of the bank to be able to absorb losses. Therefore, as a general rule of thumb, the higher the ratio, particularly the CET1 capital ratio, the better.

Tier 1 Capital Ratio Explained

The concept of tier 1 capital ratio refers to the core capital that a bank will have to keep in its reserve so that its various activities and capital requirements in terms of servicing its clients can be met. The bank tier 1 capital ratio can include certain reserves that require disclosure, certain types of assets or common stock. It is a metric to measure the financial condition and strength of the bank.

Formula of Tier 1 Capital Ratio

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Formula

The bank tier 1 capital ratio can be calculated using the formula mentioned below.

Formula

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Components

Here are some of the components of the minimum tier 1 capital ratio calculation. Let us study them in details.

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 concernGoing ConcernAny analyst analyzing a company will be left to a basic assumption that the company does not go bankrupt or file a chapter 11 bankruptcy. This basic assumption allows the analyst to think that there is no immediate danger to the company. The company can operate until infinity is called the principle of 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 tier 1 capital ratio requirement and 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 AT1 capital that can be considered Tier 1 capital at 1.5% of the bank’s risk-weighted assets.

Example

A suitable example of tier 1 capital ratio requirement will help us understand the concept in detail.

Consider an example of a bank determining its risk-weighted assets at $150,000 million. The amount 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%

From the above example, the calculation of tier 1 capital ratio of major banks is very clear and precise. We can easily understand the type of data that is taken into consideration and the steps followed to calculate the ratio.

Tier 1 Capital Vs Tier 1 Leverage Ratio

Both the above are important metrics commonly used in the financial industry. But there are some important difference between them as given below:

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.

Recommended Articles

This has been a guide to what is Tier 1 Capital Ratio. We explain the formula with example, its various components & differences with tier 1 leverage ratio. You can learn more about it from the following articles –

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