What Is the Tier 1 Capital Ratio?

The term tier 1 capital ratio refers to the ratio of a bank’s tier 1 or core capital. Financial institutions must meet a certain ratio to ensure their financial stability. Tier 1 capital is the minimum amount that a bank must hold in its reserves to finance its banking activities. This ratio measures a bank’s core equity capital against its total risk-weighted assets. Tier 1 capital is comprised of a bank's common stock, retained earnings, accumulated other comprehensive income (AOCI), noncumulative perpetual preferred stock, and any regulatory adjustments to those accounts.

Tier 1 Capital Ratio Formula

$\text{Tier 1 Capital Ratio}=\frac{\text{Tier 1 Capital}}{\text{Total Risk Weighted Assets}}\backslash text\{Tier\; 1\; Capital\; Ratio\}\; =\; \backslash frac\{\backslash text\{Tier\; 1\; Capital\}\}\{\backslash text\{Total\; Risk\; Weighted\; Assets\}\}$Tier 1 Capital Ratio=Total Risk Weighted AssetsTier 1 Capital​

Understanding Tier 1 Capital Ratio

Banks are required to hold a certain level of capital or assets in their reserves. These are divided into tiers, such as tier 1 and tier 2. Tier 1 capital refers to a bank's core capital, which it uses to run its day-to-day operations. This category includes things like retained earnings, common stock, and certain kinds of preferred stock. It does not include money deposited by customers.

As noted above, a financial institution's tier 1 capital ratio is its core capital divided by its risk-weighted assets. Financial regulators use this ratio to determine the soundness and stability of the financial system. It forms the basis of the Basel III capital and liquidity standards devised after the financial crisis that led to the Great Recession. The crisis highlighted the fact that many banks had too little capital to absorb losses or remain liquid, and were funded with too much debt and not enough equity.

To force banks to increase their capital buffers and ensure they can withstand financial distress before they become insolvent, Basel III rules tightened both tier 1 capital and risk-weighted assets. The equity component of tier-1 capital has to have at least 4.5% of RWAs. The tier 1 capital ratio has to be at least 6%.

Special Considerations

A firm's risk-weighted assets include all assets that the firm holds that are systematically weighted for credit risk. Central banks typically develop the weighting scale for different asset classes; cash and government securities carry zero risk, while a mortgage loan or car loan would carry more risk.

The risk-weighted assets would be assigned an increasing weight according to their credit risk. Cash would have a weight of 0%, while loans of increasing credit risk would carry weights of 20%, 50%, or 100%.

Tier 1 Capital Ratio vs. Other Tier 1 Ratios

The tier 1 capital ratio isn't the only ratio used in the financial industry. The tier 1 common capital ratio and tier 1 leverage ratio are two of these. We've highlighted some of the differences below.

Tier 1 Common Capital Ratio

The tier 1 capital ratio differs slightly from the tier 1 common capital ratio. Tier 1 capital includes the sum of a bank's equity capital, its disclosed reserves, and non-redeemable, non-cumulative preferred stock. Tier 1 common capital, on the other hand, excludes all types of preferred stock as well as non-controlling interests. Tier 1 common capital includes the firm's common stock, retained earnings, and other comprehensive income.

This ratio is used to determine the adequacy of a financial institution's capital and the degree to which it is capitalized.. This ratio is calculated by subtracting the institution's non-controlling interests and preferred stock from its tier 1 capital. The result is then divided by the total risk-controlling assets.

Tier 1 Leverage Ratio

The tier 1 leverage ratio is the relationship between a banking organization's core capital and its total assets. This ratio is calculated by dividing tier 1 capital by a bank's average total consolidated assets and certain off-balance sheet exposures.

The tier 1 leverage ratio is used as a tool by central monetary authorities in the same way as tier 1 capital. It ensures the capital adequacy of banks and places constraints on the degree to which a financial company can leverage its capital base but does not use risk-weighted assets in the denominator.

Basel III also introduced a minimum leverage ratio. This ratio must be at least 3% of the total assets. It's higher for global systemically important banks that are too big to fail. The Basel III rules have yet to be finalized due to an impasse between the U.S. and Europe.

Example of the Tier 1 Capital Ratio

Let's assume that ABC Bank has shareholders' equity of $3 million and retained earnings of $2 million, so its tier 1 capital is $5 million. The bank has risk-weighted assets of $50 million. Consequently, its tier 1 capital ratio is 10% ($5 million ÷ $50 million), and the bank is considered to be well-capitalized compared to the minimum requirement.

On the other hand, Bank DEF has retained earnings of $600,000 and stockholders' equity of $400,000. This means its tier 1 capital is $1 million. Bank DEF has risk-weighted assets of $25 million. Therefore, bank DEF's tier 1 capital ratio is 4% ($1 million ÷ $25 million), which is undercapitalized because it is below the minimum tier 1 capital ratio under Basel III.

Bank GHI has tier 1 capital of $5 million and risk-weighted assets of $83.33 million. Consequently, bank GHI's tier 1 capital ratio is 6% ($5 million ÷ $83.33 million), which is considered to be adequately capitalized because it is equal to the minimum tier 1 capital ratio.

The Bottom Line

The financial crisis that led to the Great Recession taught the world a valuable lesson. That is, that banks need to ensure they are adequately capitalized to prevent them from failing. Financial regulators adopted stricter rules to make sure that banks meet capital requirements. One of these is maintaining a tier 1 capital ratio of 6%. This ratio is determined by dividing a bank's tier 1 capital by the total risk-weighted assets. A bank is considered capitalized if it meets this threshold. Anything under this means that a bank may be in trouble.