What it means
Capital is not cash sitting in a vault; it is the portion of a bank's funding that belongs to its owners rather than to depositors and lenders. Tier 1 capital is the layer that takes losses first, which is exactly why regulators care about it: a bank with plenty of Tier 1 can absorb bad debts and keep lending, while a thin one has to shrink or be rescued.
Tier 1 splits into two parts. Common equity Tier 1, usually shortened to CET1, is ordinary share capital plus retained earnings and certain reserves, less deductions such as goodwill and other intangible assets.
Additional Tier 1 consists of perpetual instruments with no maturity date that can be written down or converted into shares when capital falls below a trigger. The measure that regulators, analysts and rating agencies quote is a ratio rather than an absolute amount.
Capital is divided by risk-weighted assets, where each loan is scaled according to how risky it is, so a mortgage counts for far less than an unsecured business loan of the same size. This is why two banks with identical balance sheet totals can have very different capital requirements.
Under the Basel III framework, banks must hold a minimum CET1 ratio of 4.5% and a minimum total Tier 1 ratio of 6%, with a capital conservation buffer of a further 2.5% on top, plus additional buffers for systemic importance and for the credit cycle. Falling into the buffer zone does not close a bank, but it restricts dividends, share buybacks and bonuses until the position is rebuilt.
For non-bank businesses this still matters commercially. A bank operating close to its capital requirements will ration lending, price loans higher and prefer facilities that consume less capital, so a borrower may find credit tightening for reasons that have nothing to do with its own performance.
In practice
Real-world examples.
Example
A bank planning a $2,000,000,000 share buyback withdraws the proposal after its regulator's stress test shows the CET1 ratio would drop into the conservation buffer under a severe recession scenario. The capital is retained instead, and the announcement knocks the share price back in the short term.
Example
A commercial lender shifts its new lending mix towards residential mortgages, which carry lower risk weights than unsecured corporate loans. The same volume of lending consumes less capital, lifting the reported Tier 1 ratio without any new equity being raised.
Example
A treasurer at a manufacturing company is told her bank cannot renew a $30,000,000 facility on the same terms because the exposure is capital-intensive under the bank's internal models. She splits the requirement across two lenders and provides security, reducing the risk weight and the price.
Think of it
“Tier 1 is your core capital-the strongest capital that keeps you running during losses.
Formula
Calculation
Tier 1 capital ratio = Tier 1 capital / risk-weighted assets
A mid-sized bank reports common equity Tier 1 of $10,000,000,000, made up of ordinary shares and retained earnings after deducting goodwill, plus $2,000,000,000 of additional Tier 1 instruments. Its risk-weighted assets total $100,000,000,000.
Total Tier 1 capital is $10,000,000,000 + $2,000,000,000 = $12,000,000,000. The Tier 1 capital ratio is $12,000,000,000 / $100,000,000,000 = 12%, and the CET1 ratio is $10,000,000,000 / $100,000,000,000 = 10%.
Against the 6% minimum Tier 1 requirement, the bank needs 6% x $100,000,000,000 = $6,000,000,000, so it holds a surplus of $12,000,000,000 - $6,000,000,000 = $6,000,000,000. If a wave of defaults forced a $3,000,000,000 write-down, CET1 would fall to $7,000,000,000 and the CET1 ratio to 7%, still above the 4.5% minimum but only just clear once the 2.5% conservation buffer is added.Case study
Seen in the real world.
Ambervale Regional Bank is a fictional, illustrative lender with $100,000,000,000 of risk-weighted assets and a comfortable-looking 12% Tier 1 ratio. Its board treated the surplus as spare capacity and approved an aggressive growth plan in unsecured small business lending.
Two years later, in this illustrative scenario, a regional downturn produced $3,000,000,000 of loan losses. CET1 fell from $10,000,000,000 to $7,000,000,000, cutting the CET1 ratio from 10% to 7%, which sat right on the combined minimum and conservation buffer. The regulator did not intervene, but the automatic restrictions on dividends and bonuses kicked in, and the bank had to cancel its planned distribution.
The illustrative lesson concerns the difference between surplus capital and free capital. Ambervale had grown its riskiest book fastest, so the same dollar of loss consumed more of its ratio than the board's plan assumed. Rebuilding took a discounted rights issue and two years of retained profits.
Watch out
Common mistakes.
- Thinking Tier 1 capital is cash the bank keeps in reserve, when it is a funding category on the liabilities side describing who bears losses first.
- Comparing capital ratios between banks without checking risk weights, since two banks with the same assets can face very different denominators.
- Reading the regulatory minimum as the level at which trouble starts, when buffer breaches restrict dividends and bonuses well before any minimum is hit.
Questions
People also ask.
What is the difference between CET1 and Tier 1?
CET1 is the purest element, ordinary shares and retained earnings after deductions, while total Tier 1 also includes additional Tier 1 instruments that convert or write down in a crisis.
What are risk-weighted assets?
They are a bank's assets scaled by how risky each one is judged to be, so a government bond may carry a zero weight while an unsecured business loan carries a full one.
Why does bank capital matter to an ordinary company?
Because a bank near its capital limits lends less and prices higher, which can tighten your credit availability even when your own numbers are strong.
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