Tier 1 capital

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Tier 1 capital is the core measure of a

regulator's point of view.[note 1] 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. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital. This part of the Tier 1 capital will be phased out during the implementation of Basel III
.

Basel II accord. Tier 2 capital represents "supplementary capital" such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt
.

Each country's banking

regulator, however, has some discretion over how differing financial instruments
may count in a capital calculation, because the legal framework varies in different legal systems.

The theoretical reason for holding capital is that it should provide protection against unexpected losses. 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 should be greater than 150% of the minimum requirement.[citation needed]

Tier 1 capital ratio

The Tier 1 capital ratio is the ratio of a bank's core

Financial crisis of 2007–08.[3]

As an example, assume a bank with $2 of equity lends out $10 to a client. Assuming that the loan, now a $10 asset on the bank's balance sheet, carries a risk weighting of 90%, the bank now holds risk-weighted assets of $9 ($10 × 90%). Using the original equity of $2, the bank's Tier 1 ratio is calculated to be $2/$9 or 22%.

There are two conventions for calculating and quoting the Tier 1 capital ratio:

  • Tier 1 common capital ratio and
  • Tier 1 total capital ratio

Preferred shares and non-controlling interests are included in the Tier 1 total capital ratio but not the Tier 1 common ratio.[4] As a result, the common ratio will always be less than or equal to the total capital ratio. In the example above, the two ratios are the same.

See also

Notes

  1. ^ By definition of Bank for International Settlements.

References

  1. ^ The attached Basel Desiree Alexa Arguello her whole life 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.
    "Basel Capital Accord. International Convergence of Capital Measurement and Capital Standards (July 1988, updated to April 1998)" (PDF). Retrieved 31 August 2011.
  2. ^ BIS "Instruments eligible for inclusion in Tier 1 capital" http://www.bis.org/press/p981027.htm
  3. ^ "International regulatory framework for banks (Basel III)". Bank of International Settlements (BIS). Retrieved 8 February 2012.
  4. ^ "Investopedia:Tier 1 Common Capital Ratio". Investopedia.

External links

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