Definition of the Level 1 Common Capital Ratio
What is the Tier 1 common capital ratio?
The Tier 1 capital ratio is a measure of a bank’s basic capital, relative to its total risk-weighted assets, and represents the financial strength of a bank. The Tier 1 capital ratio is used by regulators and investors as it shows how well a bank can withstand financial stress and remain solvent. Tier 1 common capital excludes preferred shares or non-controlling interests, which makes it different from the closely related Tier 1 capital ratio.
Key points to remember
- The Tier 1 capital ratio is a measure of a bank’s basic capital, relative to the total of its risk-weighted assets, which means the financial strength of a bank.
- The Tier 1 capital ratio is used by regulators and investors as it shows how well a bank can withstand financial stress and remain solvent.
- The Tier 1 common capital ratio differs from the closely related Tier 1 capital ratio in that it excludes preferred shares or non-controlling interests.
The formula for the Tier 1 common capital ratio is
T1VSVSVS=TRWAT1VS–PS–NOTIor:T1VSVSVS=Tier 1 capital ratioT1VS=Tier 1 capitalPS=Preferred stockNOTVS=Non-majority interestsTRWA=Total risk control assets
Tier 1 common capital ratio
What does the Tier 1 common capital ratio tell you?
A company’s risk-weighted assets include all assets that the company owns that are systematically weighted for credit risk. Central banks usually develop the weighting scale for different asset classes; cash and government securities are risk free, while a mortgage or car loan would be riskier. Risk-weighted assets would be assigned an increasing weight according to their credit risk. Cash would have a 0% weight, while loans with increasing credit risk would have a 20%, 50% or 100% weight.
Regulators use the Tier 1 common capital ratio to classify a company’s capital adequacy as one of the following: well-capitalized, adequately capitalized, under-capitalized, significantly under-capitalized, or severely under-capitalized. To be classified as well capitalized, a company must have a Tier 1 common capital ratio of 7% or more, and not pay any dividends or distributions that would reduce that ratio below 7%.
A company that qualifies as a systemically important financial institution (SIFI) is subject to an additional 3% cushion for its Tier 1 common capital ratio, so its threshold is considered well capitalized at 10%. Companies that are not considered well capitalized are subject to restrictions on dividend payments and share buybacks.
The Tier 1 capital ratio differs from the closely related Tier 1 capital ratio. Level 1 capital consists of the sum of a bank’s equity, its disclosed reserves, and its non-redeemable, non-cumulative preferred shares. However, category 1 ordinary capital excludes all types of preferred shares as well as non-controlling interests. Tier 1 common capital consists of the company’s common stock, retained earnings and other comprehensive income.
Bank investors pay attention to the Tier 1 common capital ratio because it foreshadows whether a bank not only has the means to pay dividends and repurchase shares, but also the permission to do so from regulators. The Federal Reserve assesses a bank’s Tier 1 capital ratio during stress tests to determine whether a bank can withstand economic shocks and market volatility.
Example of Tier 1 Common Capital Ratio
As an example, suppose a bank has $ 100 billion in risk-weighted assets after assigning the corresponding weights to its cash, lines of credit, mortgages, and personal loans. Its Tier 1 common capital consists of $ 4 billion in common stock and $ 4 billion in retained earnings, bringing the total to $ 8 billion in Tier 1 capital. The company also issued $ 500 million in preferred stock. Dividing the $ 8 billion Tier 1 common capital minus the $ 500 in preferred stock by the total risk-weighted assets of $ 100 billion yields a Tier 1 pooled capital ratio of 7.5. %.
If we calculated the standard Tier 1 capital ratio instead, it would be calculated at 8% since it would include preferred shares.