Tier 1 Capital

What Is Tier 1 Capital?

Tier 1 capital is used to describe the capital adequacy of a bank and refers to core capital that includes equity capital and disclosed reserves. Equity capital is inclusive of instruments that cannot be redeemed at the option of the holder.

Tier 1 capital is essentially the most perfect form of a bank’s capital — the money the bank has stored to keep it functioning through all the risky transactions it performs, such as trading/investing and lending.

Broadly speaking, tier 1 capital ensures that a bank has adequate capital reserves to absorb losses. Effectively, this promotes both transparency and financial discipline among banking institutions, while protecting taxpayers from exposure to loss.

How Tier 1 Capital Works

From a regulatory point of view, tier 1 capital is the core measure of the financial strength of a bank because it is composed of core capital. Importantly, core capital is composed primarily of disclosed reserves (also known as retained earnings) and common stock. It can also include noncumulative, nonredeemable preferred stock.

Equity capital is inclusive of instruments that cannot be redeemed at the option of the holder.

Since tier 1 capital represents the highest tier of capital, these funds serve as a cushion for absorbing potential loss.

Tier 1 capital requirements are defined under Basel III, which was developed in order to respond to deficiencies in financial regulation that were exposed by the world financial crisis in 2007 and 2008. Under Basel III requirements, banks must have a 6% tier 1 capital ratio, at a minimum. 

The tier 1 capital ratio compares a bank’s equity capital with its total risk-weighted assets (RWAs). RWAs are all assets held by a bank that are weighted by credit risk. Most central banks set formulas for asset risk weights according to the Basel Committee’s guidelines.

Tier 1 Capital vs. Tier 2 Capital

Tier 1 capital is the primary funding source of the bank. Typically, it holds nearly all of the bank's accumulated funds. These funds are generated specifically to support banks when losses are absorbed so that regular business functions do not have to be shut down.

Under the issued version of Basel III, the minimum tier 1 capital ratio is 6%. This ratio is calculated by dividing tier 1 capital by its total risk-based assets. These risk-weighted assets may include commercial, mortgage loans, or U.S. Treasury bonds, among others. In turn, assets are assigned a risk coefficient that is determined by their credit rating. Typically, assets backed by collateral are assigned lower levels of risk.

Tier 2 capital includes hybrid capital instruments, loan-loss and revaluation reserves as well as undisclosed reserves. This capital operates as supplementary funding because it is not as reliable as the first tier. In other words, tier 2 capital is not as easy to liquidate as tier 1 capital. In 2019, under Basel III, the minimum total capital ratio was 8%, which indicates the minimum tier 2 capital ratio is 2%, as opposed to 6% for the tier 1 capital ratio.

Example of Tier 1 Capital

Let's say a bank’s tier 1 capital consists of $2.5 million in retained earnings and $3.5 million in shareholder equity. The bank’s tier 1 capital would equal $6 million. 

Now, consider that the bank has risk-weighted assets valued at $60 million. To calculate the tier 1 capital ratio, the tier 1 capital of $6 would be divided by the risk-weighted assets of $60 million, to equal 10%. Under Basel III, this presents a bank that is capitalized above the minimum tier 1 capital ratio of 6%.