Key Aspects of Common Equity Tier 1 (CET1)
Common Equity Tier 1 (CET1) forms a core part of Tier 1 capital, consisting primarily of common stock held by banks and other financial institutions. It serves as a vital capital measure introduced in 2014 to shield the economy from financial crises. By requiring banks to maintain minimum CET1 ratios relative to their risk-weighted assets (RWAs), financial regulators aim to ensure sufficient liquidity and stability within the banking system.
Key Highlights
- CET1 Coverage: It includes liquid assets such as cash and stock.
- CET1 Ratio: This ratio matches a bank’s capital to its assets for comparison.
- Additional Tier 1 Capital (AT1): Comprises instruments that are not common equity.
- Crisis Protection: Tier 1 equity is the first line of defense in financial disturbances.
- Stress Testing: Many banking stress tests begin with examining Tier 1 capital to evaluate a bank’s crisis resilience.
The Role of CET1 in Financial Stability
In the aftermath of the 2007-2008 financial crisis, the Basel Committee developed international standards, collectively known as Basel III, to assess and monitor banks’ capital adequacy. These standards compare a bank’s assets to its capital, ensuring that banks hold sufficient capital to endure financial downturns.
Bank capital is essential for absorbing unexpected losses that occur during regular operations. Basel III regulations restrict the kinds of capital banks can include in their capital structure.
Tiers of Capital:
- Tier 1 Capital: Also known as core capital or going concern capital, this tier includes CET1 and Additional Tier 1 (AT1) capital, and supports a bank’s fundamental business activities.
- Tier 2 Capital: Referred to as supplementary or gone-concern capital, it includes subordinated term debt and hybrid capital instruments.
- Tier 3 Capital: Includes lower-quality capital to cover market, commodity, and currency risks.
CET1, recognized as the “highest quality of regulatory capital,” is crucial for immediate loss absorption. Banks must maintain a CET1 ratio of at least 4.5% of their risk-weighted assets to remain compliant.
Special Considerations for CET1
Banks typically structure their capital into Lower Tier 2, Upper Tier 1, AT1, and CET1 categories. CET1 is positioned at the base of this structure, making it the first to suffer losses in financial crises. Dropping below the regulatory CET1 ratio threshold prompts a bank to restore its capital levels or face regulatory actions, including possibly halting dividend payouts or employee bonuses. Equity holders absorb losses first if insolvency occurs.
Stress Tests evaluate a bank’s CET1 ratio under adverse financial scenarios to determine resilience. Results show that many banks remain robust in crisis conditions.
How CET1 Capital Is Calculated
Common Equity Tier 1 capital is part of Tier 1 capital, which also includes AT1 capital. CET1 accounts for a bank’s core capital: common shares, stock surpluses, retained earnings, common shares issued by subsidiaries, and accumulated other comprehensive income (AOCI).
Formula:
Common Equity Tier 1 Ratio = Common Equity Tier 1 Capital ÷ Risk-Weighted Assets
Not all assets pose equal risk, thus they are weighted according to associated credit and market risks. For instance, government bonds are often seen as “no-risk assets” with zero percent risk weighting, while subprime mortgages might carry up to 65% weighting. Basel III mandates a minimum CET1 to RWAs ratio of 4.5%.
Differentiating Between Tier 1 Capital and CET1
CET1 forms a subset of Tier 1 capital. Together with Additional Tier 1 (AT1) capital, they make up the total Tier 1 capital.
Regulatory Minimums for Bank Capital
Banks are required by the Basel Accords to maintain a minimum total capital ratio of 8%, with at least 6% of that in Tier 1 capital.
Implications of a Low CET1 Ratio
A low CET1 ratio indicates a lack of sufficient Tier 1 capital, suggesting that the bank might struggle to absorb financial shocks, potentially necessitating a bailout during a crisis.
Related Terms: Banking Regulations, Financial Stability, Capital Adequacy, Basel Accords
References
- International Monetary Fund. “Financial Stability in the New High-Inflation Environment”. Page 31.
- Federal Reserve Board. “Federal Reserve Supervision and Regulation Report - November 2018”.
- Bank for International Settlements. “Basel III: International Regulatory Framework for Banks”.
- Bank for International Settlements. “Basel Committee on Banking Supervision: High-level summary of Basel III reforms”. Pages 1-2.
- Federal Reserve Bank of San Francisco. “What Is Bank Capital and What are the Levels or Tiers of Capital?”
- Bank for International Settlements. “Definition of Capital in Basel III – Executive Summary”. Page 1.
- Federal Reserve Bank of Boston. “Partial Effects of Fed Tightening on U.S. Banks’ Capital”.
- Bank of International Settlements. “Risk-based Capital Requirements”.
- FDIC. “Capital”.
- European Banking Authority. “EBA Publishes the Results of its 2023 EU-wide Stress Test”.
- Bank for International Settlements. “Basel Committee on Banking Supervision: High-level summary of Basel III reforms”. Page 9.
- Cornell University, Legal Information Institute. "§ 3.10 Minimum Capital Requirements".
