Tier 1 Capital Ratio Definition Formula How To Calculate

Tier 1 Capital Ratio

Explanation

The Global Financial CrisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more of 2008 highlighted the weak capital and loss absorption capacity of many financial institutions internationally. Discounts were observed in the computation of capital across geographies and jurisdictions, which reduced the comparability of capital ratios and shook confidence in the reported figures.To ensure that high-quality capital was reckoned and to bring about uniformity in the computation of capital ratios of financial institutions, the international committee of banking supervisors – the Basel Committee on Banking Supervision, issued the Basel III accord.Basel III norms emphasized increasing the loss-absorbing capacity of banks to be better prepared for financial crisis events by strengthening the banks’ capital ratios. Basel IIIBasel IIIBasel III is a regulatory framework designed to strengthen bank capital requirements while also mitigating risk. It is an extension in the Basel Accords, designed and agreed upon by members of the Basel Committee on Banking Supervision.read more norms required a minimum Tier 1 capital ratio of 6% and the total capital ratio of 8%. The III accord also requires banks to maintain a capital buffer of 2.5% over and above the total capital requirement of 8% to provide additional comfort.

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Formula

Risk-weighted assetsRisk-weighted AssetsRisk-weighted asset refers to the minimum amount that a bank or any other financial institution must maintain to avoid insolvency or bankruptcy risk. The risk associated with each bank asset is analyzed individually to figure out the total capital requirement.read more are the bank’s assets and certain off-balance sheet exposures weighted by the risk weights assigned to the particular categories of the exposures as per regulatory norms. Riskier exposures are assigned higher weights indicating a higher capital requirement to cushion any losses and vice versa.The higher the bank’s ratio, the higher its loss-absorbing capacity would be.

Components

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

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.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.

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 AT1 capital that can be considered 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 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:

Alternatively,

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

Ratio = CET1 Ratio + AT1 Ratio

= 6.33% + 0.67%
= 7%

Tier 1 Capital vs. Tier 1 Leverage Ratio

Tier 1 Capital ratioTier 1 Capital RatioLeverage ratios for banks depict a bank’s overall financial health and efficiency, including its debt-paying capacity and fund management ability. The financial institution evaluates the Tier 1 leverage ratio, debt to equity ratio and debt to capital ratio for this purpose.read more measures the bank’s Tier 1 capital proportion to its total assets, including certain off-balance sheet exposures, as opposed to risk-weighted assets considered in the Tier 1 capital ratio calculation. Total assetsTotal AssetsTotal Assets is the sum of a company’s current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more considered for the bank’s leverage ratio are not risk-weighted.

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.

The Basel III norms introduced Tier 1 leverage ratio to prevent banks from excessively leveraging their businesses. Basel III prescribes a minimum Tier 1 leverage ratio of 3%.Banks considered too big to failToo Big To FailToo Big to Fail (TBTF) is a term used in banking and finance to describe businesses that have a significant economic impact on the global economy and whose failure could result in worldwide financial crises. Because of their crucial role in keeping the financial system balanced, governments step into saving such interconnected institutions in the event of a market or sector collapse.
read more, the failure expected to harm 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 the bank and its relative importance, its interconnectedness with the economies across jurisdictions, and the 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 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.