How do I calculate the Tier 1 capital ratio?
Level 1 capital under the Basel Accord measures the capital base of a bank. The Tier 1 capital ratio measures the financial health of a bank, its basic capital in relation to its total risk-weighted assets (RWA). Under Basel III, banks and financial institutions must maintain a minimum Tier 1 capital ratio to protect against unexpected losses such as those that occurred during the 2008 financial crisis. The Tier 1 capital ratio minimum is 10.5%.
Tier 1 common capital ratio
Tier 1 capital explained
Tier 1 capital includes equity and retained earnings of a bank. Risk-weighted assets are the assets of a bank weighted according to their risk exposure. For example, cash is risk-free, but different risk weights apply to particular loans such as mortgages or business loans. The risk weight is a percentage applied to the corresponding loans to reach the total risk weighted assets. To calculate a bank’s Tier 1 capital ratio, divide its Tier 1 capital by the total of its risk-weighted assets.
The minimum Tier 1 capital ratio.
Tier 2 capital
Level 2 capital is made up of any additional capital the bank has, such as loan loss and revaluation reserves and undisclosed reserves. Level 2 capital is considered separately in the analysis of banking risks because it is generally less secure than level 1 capital.
Tier 1 capital requirements
The Tier 1 capital ratio can be expressed as the total core capital of a bank or as the Tier 1 common capital ratio or the CET1 ratio. The CET1 ratio excludes preferred shares and non-controlling interests from the total amount of Tier 1 capital; therefore, it is always less than or equal to the total capital ratio.
Under the Basel Accords, banks must have a minimum capital ratio of 8% of which 6% must be Tier 1 capital. The Tier 1 ratio of 6% must be composed of at least 4.5% of CET1.
In 2-19, Basel III requirements will be fully implemented and banks will need a mandatory “capital conservation buffer” of 2.5% of the bank’s risk-weighted assets, which brings the total minimum CET1 to 7% (4.5% plus 2.5%). In the event of strong credit growth, banks may need an additional buffer of up to 2.5% of risk-weighted capital, consisting of CET1 capital.
Loans are assets for banks
Although it seems counterintuitive, loans are considered assets for banks because banks earn income from loans in the form of interest from borrowers. On the other hand, deposits are liabilities since the bank pays interest to deposit holders.
Determine if a bank is well capitalized
Regulators use the Tier 1 capital ratio to determine whether a bank is well-capitalized, under-capitalized, or adequately capitalized against the minimum requirement.
For example, ABC Bank has equity of $ 3 million and retained earnings of $ 2 million, so its Tier 1 capital is $ 5 million. ABC Bank has risk weighted assets of $ 50 million. Therefore, the bank’s Tier 1 capital ratio is 10% ($ 5 million / $ 50 million) and it is considered well capitalized against the minimum requirement.
On the other hand, DEF Bank has retained earnings of $ 600,000 and equity of $ 400,000. Thus, his level 1 capital is $ 1 million. DEF Bank has risk-weighted assets of $ 25 million. Therefore, the DEF bank’s Tier 1 capital ratio is 4% ($ 1 million / $ 25 million), which is under-capitalized because it is below the minimum Tier 1 capital ratio. of Basel III.
GHI Bank has Tier 1 capital of $ 5 million and risk-weighted assets of $ 83.33 million. Therefore, the Tier 1 capital ratio of GHI bank is 6% ($ 5 million / $ 83.33 million), which is considered sufficiently capitalized because it is equal to the capital ratio of category 1 minimum.