Tier 1 common capital ratio is a pivotal measurement of a bank’s core equity capital in comparison to its total risk-weighted assets. It serves as an indicator of a bank’s financial robustness and ability to withstand financial distress while remaining solvent. Differing from the Tier 1 capital ratio, Tier 1 common capital ratio excludes preferred shares and non-controlling interests.
Key Takeaways
- Reflects the financial strength of a bank in relation to its core equity capital against risk-weighted assets.
- Widely used by regulators and investors to assess a bank’s resilience to financial stress.
- Unlike the Tier 1 capital ratio, it excludes preferred shares and non-controlling interests.
The Formula for the Tier 1 Common Capital Ratio
Calculating the Tier 1 common capital ratio involves a straightforward formula:
$$ T1CCC = \frac{T1C - PS - NI}{TRWA} $$
- T1CCC - Tier 1 Common Capital Ratio
- T1C - Tier 1 Capital
- PS - Preferred Stock
- NI - Non-controlling Interests
- TRWA - Total Risk-Weighted Assets
What Does the Tier 1 Common Capital Ratio Tell You?
A firm’s risk-weighted assets encompass all its holdings, systematically adjusted for credit risk. Typically, central banks assign a risk weight to different asset classes. For instance, cash and government securities may receive a weight of 0%, while mortgage and car loans might carry higher risk weights.
Regulators categorize capital adequacy based on the Tier 1 common capital ratio into several ratings: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, or critically undercapitalized. A well-capitalized institution must maintain a Tier 1 common capital ratio of at least 7% without reducing it through dividends or other distributions.
For systemically important financial institutions (SIFIs), an additional buffer of 3% is often required, setting their threshold at 10% to be considered well-capitalized. Institutions that do not meet the well-capitalized criteria face restrictions on dividends and share buybacks.
Unlike the broader Tier 1 capital ratio, which includes equity capital, disclosed reserves, and certain types of preferred stock, the Tier 1 common capital ratio focuses solely on common stock, retained earnings, and other comprehensive income, avoiding any preferred share inclusion.
Investors monitor the Tier 1 common capital ratio to gauge a bank’s ability not only to pay dividends and repurchase shares but also to understand the regulatory stance on such actions. Regulatory bodies like the Federal Reserve also review this ratio during stress tests to evaluate a bank’s capacity to endure economic and market volatility.
Example of the Tier 1 Common Capital Ratio
Let’s look at a hypothetical example. Suppose a bank assigns weights to its $100 billion in risk-weighted assets, including cash, credit lines, mortgages, and personal loans. The bank’s Tier 1 common capital comprises $4 billion in common stock and $4 billion in retained earnings, totaling $8 billion. If the bank has issued $500 million in preferred shares, the calculation is as follows:
$$ \text{Tier 1 common capital} = 8 , \text{billion} - 500 , \text{million} \text{ preferred shares} = 7.5 , % $$
This leads to a Tier 1 common capital ratio of 7.5%. In contrast, the standard Tier 1 capital ratio, which does include preferred shares, would be 8%.
