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Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital,^[1] which consists primarily of common stock and disclosed reserves (or retained earnings),^[2] but may also include non-redeemable non-cumulative preferred stock.

Capital in this sense is related to, but different from, the accounting concept of shareholders' equity. Both tier 1 and tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord. Tier 2 capital is senior to Tier 1, but subordinate to deposits and the deposit insurer's claims. These include preferred stock with fixed maturities and long-term debt with minimum maturities of over five years.

Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems.

The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses which are covered by provisions, reserves and current year profits. In Basel I agreement, Tier 1 capital is a minimum of 4% ownership equity but investors generally require a ratio of 10%.

Tier 1 capital ratio

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets. The Tier 1 risk based capital ratio is the ratio of a bank's core (equity capital) to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country's central bank). Most central banks follow the Bank for International Settlements (BIS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%.

A good definition of Tier 1 capital is that it includes equity capital and disclosed reserves, where equity capital includes instruments that can't be redeemed at the option of the holder (meaning that the owner of the shares cannot decide on his own that he wants to withdraw the money he invested and so cannot leave the bank without the risk coverage). Reserves are held by the bank, and are thus money that no one but the bank can have an influence on.

Tier 1 capital is seen as a metric of a bank's ability to sustain future losses. It is the way to track how much risk any particular bank is taking on, in terms of dollars held per dollars loaned out.

A 10% Tier 1 capital ratio may approximate but does not mean that a bank is holding in its vaults $1 for every $10 that a customer has in their account balance. The ratio looks across the columns of the balance sheet. The $10 that the customer has deposited is a liability of the bank. The bank must have started with some equity capital, say $2. The ratio requires that we investigate what the bank does with those $12 (equity of $2 plus deposit of $10). If the bank lends $9 and invests $3 in Treasury securities, the question whether the Bank complies with its capital requirements will depend on the risk-adjusted asset-value of the claim against the borrower for $9 that the bank holds. If the risk-adjusted value of that is 90% or $8.10, then (assuming the $3 Treasury deposit is valued at 100%) the bank's risk-adjusted assets would be $8.10. Therefore the tier 1 ratio is $2 / 8.1 or 25%. Since the formula is calculated as Capital divided by Risk Adjusted Assets.

References

^ The attached Basel Capital Accord shows the definitions of core capital and tier 1 capital in pages 3 and 4, section "The constituents of capital (a) Core capital (basic equity)". This relationship is shown again in Annex 1.
"Basle Capital Accord. International Convergence of Capital Measurement and Capital Standards (July 1988, updated to April 1998)" (PDF). Retrieved 2008–11–30. {{cite web}}: Check date values in: |accessdate= (help)
^ BIS "Instruments eligible for inclusion in Tier 1 capital" http://www.bis.org/press/p981027.htm

External links

"[[Bank for International Settlements]] (BIS)". {{cite web}}: URL–wikilink conflict (help)

[1] The attached Basel Capital Accord shows the definitions of core capital and tier 1 capital in pages 3 and 4, section "The constituents of capital (a) Core capital (basic equity)". This relationship is shown again in Annex 1.
"Basle Capital Accord. International Convergence of Capital Measurement and Capital Standards (July 1988, updated to April 1998)" (PDF). Retrieved 2008–11–30. {{cite web}}: Check date values in: |accessdate= (help)

[2] BIS "Instruments eligible for inclusion in Tier 1 capital" http://www.bis.org/press/p981027.htm

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 Tier 1 capital is seen as a metric of a bank's ability to sustain future losses. It is the way to track how much risk any particular bank is taking on, in terms of dollars held per dollars loaned out.
-A 10% Tier 1 capital ratio may approximate but does not mean that a bank is holding in its vaults $1 for every $10 that a customer has in their account balance. The ratio looks across the columns of the balance sheet. The $10 that the customer has deposited is a liability of the bank. The bank must have started with some equity capital, say $2. The ratio requires that we investigate what the bank does with those $12 (equity of $2 plus deposit of $10). If the bank lends $9 and invests $3 in Treasury securities, the question whether the Bank complies with its capital requirements will depend on the risk-adjusted asset-value of the claim against the borrower for $9 that the bank holds. If the risk-adjusted value of that is 90% or $8.10, then (assuming the $3 Treasury deposit is valued at 100%) the bank's risk-adjusted assets would be $11.10, implying a Tier 1 capital requirement of $1.10. The bank's liabilities are $10. Subtracted from $11.10, they leave Tier 1 capital of $1.10, so the bank is in compliance, albeit barely. Some call the loan of $9 that the bank was able to make in these circumstances [[fiat money]] because it creates the appearance that more money is in circulation than was issued by the central bank. In this example, the most that the central bank could have issued would be the $2 equity plus the $10 deposit, yet the borrower together with the depositor, believe they can purchase $19 of goods and the bank's equityholders believe they hold equity of $2. Thus, even in an economy of specie or [[hard money]], [[fiat money]] will exist to the extent permitted by [[bank regulation]].
+A 10% Tier 1 capital ratio may approximate but does not mean that a bank is holding in its vaults $1 for every $10 that a customer has in their account balance. The ratio looks across the columns of the balance sheet. The $10 that the customer has deposited is a liability of the bank. The bank must have started with some equity capital, say $2. The ratio requires that we investigate what the bank does with those $12 (equity of $2 plus deposit of $10). If the bank lends $9 and invests $3 in Treasury securities, the question whether the Bank complies with its capital requirements will depend on the risk-adjusted asset-value of the claim against the borrower for $9 that the bank holds. If the risk-adjusted value of that is 90% or $8.10, then (assuming the $3 Treasury deposit is valued at 100%) the bank's risk-adjusted assets would be $8.10. Therefore the tier 1 ratio is $2 / 8.1 or 25%. Since the formula is calculated as Capital divided by Risk Adjusted Assets.
 == See also ==