Unveiling Essential Aspects of Tier 1 Capital: Impact on Banking Sector

In the world of banking, maintaining financial stability is paramount. One of the key factors that contribute to this stability is Tier 1 capital. This article aims to shed light on what Tier 1 capital is, its components, and its significance, particularly in the context of the Basel III and Basel IV agreements.

What is Tier 1 Capital?

Tier 1 capital represents the strongest form of a bank's capital. It consists of shareholder equity, disclosed reserves, and certain other income. In essence, it's a measure of a bank's core strength.

Tier 1 capital is divided into two main components: Common Equity Tier 1 (CET1) and Additional Tier 1. CET1, the main component, is the strongest form of capital that can be quickly liquidated to absorb unexpected losses, ensuring the bank's continued operation.

CET1 comprises common stock and stock surplus, retained earnings, qualifying minority interest, and certain other income. On the other hand, Additional Tier 1 Capital consists of preferred stock, related surplus, and qualifying minority interest.

The Role of CET1

CET1, being the highest quality of Tier 1 capital, absorbs losses immediately, including common shares, retained earnings, other comprehensive income, and minority interest. It plays a crucial role in maintaining financial stability, particularly under the Basel III agreement.

Adopted by the Basel Committee on Banking Supervision in 2010, the Basel III accord mandates a minimum Tier 1 capital ratio of 6% of risk-weighted assets to ensure financial stability. Under these standards, banks must maintain the equivalent of 6% of their risk-weighted assets in Tier 1 capital.

The Basel III agreement also sets the CET1 capital ratio minimum at 4.5%. This requirement, along with the total amount of reserve capital (Tier 1 and Tier 2) being over 8%, aims to provide a robust safety net for banks.

Basel IV: A Step Further

The Basel IV standards, adopted in 2017, started to take effect in January 2023. These standards fine-tune the calculations of credit risk, market risk, and operations risk, and enhance the leverage ratio framework for certain banks.

Basel IV impacts each bank's business model differently, reflecting the committee's efforts to tailor regulations to individual bank's risk profiles.

Tier 1 vs Tier 2 Capital

While Tier 1 capital is intended to absorb unexpected losses and allow the bank to continue operating as a going concern, Tier 2 capital, often described as "gone concern" capital, helps cover obligations in a bank failure before affecting depositors, lenders, and taxpayers.

In summary, Tier 1 capital, and particularly CET1, plays a vital role in maintaining financial stability by absorbing losses and ensuring a bank's continued operation. The Basel III and Basel IV agreements have strengthened the requirements for Tier 1 capital, aiming to protect the banking sector and, by extension, the global economy.