What it means
Banks lend out other people's money, so they need a cushion of their own funds to absorb losses. The best cushion is common equity, which has no fixed payments and is the first to bear any loss.
The Tier 1 common capital ratio compares this cushion with the size of the bank's risk-weighted assets. Risk-weighted assets are the bank's loans and investments adjusted for how risky they are.
A government bond carries a very low weight, while an unsecured business loan carries a higher one. This adjustment means a bank with safe assets needs less capital than one with risky assets of the same size.
Capital rules agreed internationally by the Basel Committee on Banking Supervision, and applied by national regulators, require banks to hold a minimum ratio, plus extra buffers in good times. Banks that fall below the requirements face restrictions on paying dividends and bonuses.
Exact levels differ by country and by institution and change as rules are updated. The ratio rose in importance after the 2007 to 2009 financial crisis, when regulators concluded that some banks had held too little high-quality capital.
The newer measure called common equity Tier 1 focuses on exactly this kind of capital. Banks improve the ratio by retaining profits, issuing new shares or reducing risky assets.
For a non-specialist, the ratio is easy to read in a bank's annual report. A higher number means a thicker cushion, but it also means the bank may be earning less on its equity.
Managers choosing a bank for deposits or credit lines can use it as one indicator of resilience, alongside funding and loan quality. The ratio can be improved in two ways, by raising the top line of the fraction or lowering the bottom.
Raising capital through retained profit or new shares increases the numerator, while selling or shrinking risky assets reduces the denominator. Investors watch which route a bank takes, because cutting assets can mean less lending to the economy.
In practice
Real-world examples.
Example
A bank analyst compares two lenders and finds that one has a Tier 1 common ratio of 12% and the other 8%. She notes that the first has a thicker cushion against loan losses. She then checks the quality of each bank's loans before drawing conclusions.
Example
A bank's finance team plans a large increase in mortgage lending. They estimate that the extra risk-weighted assets will lower the ratio by 0.5 percentage points. The board decides to retain more profit this year, so the ratio stays above its internal target.
Example
A corporate treasurer chooses banks for a syndicated loan. She asks each bank for its latest capital ratios and reviews them alongside credit ratings. She prefers lenders with comfortable margins over the regulatory minimum, and she records the figures in her counterparty file. She reviews them again each time the banks publish new results.
Formula
Calculation
Tier 1 common capital ratio (%) = Tier 1 common capital / Risk-weighted assets x 100
Suppose a bank has common shares and retained earnings of $9,000,000,000 after regulatory deductions, and risk-weighted assets of $90,000,000,000. The ratio is 9,000,000,000 / 90,000,000,000 x 100 = 10%. If the bank makes a loss of $1,800,000,000, its common capital falls to $7,200,000,000, and the ratio becomes 7,200,000,000 / 90,000,000,000 x 100 = 8%. If it then cuts risk-weighted assets to $72,000,000,000, the ratio returns to 7,200,000,000 / 72,000,000,000 x 100 = 10%.Case study
Seen in the real world.
Northern Crest Bank is an illustrative, fictional lender with $60,000,000,000 of risk-weighted assets and Tier 1 common capital of $5,400,000,000, giving a ratio of 9%. Its board had set an internal target of 10% to maintain a safety margin above the regulatory minimum.
To close the gap of one percentage point, the bank needed another $600,000,000 of common capital, since 1% of $60,000,000,000 is $600,000,000. Management considered three options: issuing new shares, retaining all profits for a year or selling a portfolio of higher-risk loans.
In this illustrative story, the bank chose to retain profits and sell a $4,000,000,000 portfolio of risky loans carrying a 100% risk weight. That cut risk-weighted assets to $56,000,000,000 and raised the ratio to 5,400,000,000 / 56,000,000,000 = about 9.6% immediately, and it passed 10% once the retained profits were added.
Watch out
Common mistakes.
- Comparing ratios across banks without noticing that each applies risk weights in a slightly different way.
- Assuming a higher ratio always means a better bank, when excess capital can also mean weak profitability. A balanced view looks at returns on equity as well as the strength of the cushion.
- Confusing the ratio with the leverage ratio, which divides capital by total assets without risk weights.
Questions
People also ask.
What counts as Tier 1 common capital?
Mainly common shares, retained earnings and certain reserves, after deducting items such as goodwill.
Why are risk weights used?
They make the requirement fit the risk, so that safer assets need less capital than riskier ones.
Is there a single required level?
No, the minimum and buffers are set by regulators and differ by country and bank, so the current requirement should be checked. Banks also set internal targets above the minimum to allow for unexpected losses.
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