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Common Equity Tier 1 (CET1)



Definition

Common Equity Tier 1 (CET1) is a measurement of a bank’s core capital, used in the context of capital adequacy of a bank. It’s predominantly comprised of common shares, retained earnings, and other common equity. CET1 provides the most accurate indication of a bank’s financial health, as it represents the capital a bank has available to absorb losses before it becomes insolvent.

Phonetic

“Common Equity Tier 1” is phonetically presented as /ˈkɑːmən ‘ɛkwɪti tɪər wʌn/, and “CET1” is typically pronounced as /siː iː tiː wʌn/.

Key Takeaways

  1. CET1 stands for Common Equity Tier 1: This is a measure used by regulatory bodies like Central Banks and the Basel Committee on Banking Supervision to evaluate the core capital of banks consequently improving the financial strength and stability of banks. CET1 includes common shares, retained earnings, other comprehensive income, and other disclosures.
  2. Function of CET1: CET1 is utilized to act as a buffer against a bank’s unexpected financial loss or to absorb them when they do occur. It enables stakeholders, including shareholders, banking regulators, and depositors to assess a bank’s ability to withstand economic downturns or financial stresses.
  3. Optimal CET1 Ratio: A higher CET1 ratio denotes a more financially stable and capital sufficient bank. By global standards established through the Basel III regulation, a minimum CET1 ratio of 4.5% is required for all banks. Though it is important to note, a higher ratio provides more investor confidence, consequently motivating banks to prefer ratios significantly above the minimum threshold.

Importance

The Common Equity Tier 1 (CET1) is a critical measure in finance and banking as it gauges a bank’s capital strength, financial stability, and readiness to withstand financial adversities. It primarily comprises a bank’s tangible common equity capital, which is the most basic form of bank capital. Regulators monitor CET1 ratios to ensure that banks hold an adequate buffer of capital that can absorb losses, thus minimizing the risk of insolvency. A robust CET1 ratio typically indicates a financially healthy and resilient bank that can protect depositor interests. Therefore, it is pivotal in assessing the robustness of a financial institution and ensuring the overall stability and integrity of the financial system.

Explanation

Common Equity Tier 1 (CET1) serves as an important metric in determining the financial strength and stability of a bank or any financial institution. Specifically, it acts as an indicator of a bank’s capacity to absorb losses without jeopardizing its own financial standing or the interests of its depositors and investors. By quantifying the core capital of a bank, CET1 becomes an essential tool in managing the risks associated with bank operations, encompassing credit risk, operational risk, and market risk. Adequate capital reserves as represented by CET1 allow banks to remain solvent and continue their operations even in the midst of financial downturns.CET1 also plays a critical role in the regulation and oversight of the banking industry. Regulators use this ratio to evaluate a bank’s capital adequacy under various stress scenarios and to decide whether the bank has enough capital buffer to meet its financial obligations. From a regulatory perspective, a higher CET1 ratio is generally preferred, indicating a greater ability to withstand financial distress. In addition, as part of Basel III framework, banks are required to maintain a CET1 ratio of at least 4.5% to ensure their financial resilience, thereby safeguarding the larger financial system.

Examples

1. Deutsche Bank: In 2018, Deutsche Bank’s CET1 ratio greatly concerned regulators and investors. In the second quarter of 2018, the German bank’s CET1 ratio fell to 13.3%, dipping below its target of 13.5%. The drop was a result of corporate restructuring, operational losses, and a high level of risk-weighted assets.2. Wells Fargo: Wells Fargo consistently demonstrates a strong CET1 ratio. As of the fourth quarter of 2020, the U.S. bank reported a CET1 ratio of 11.6%, exceeding the regulatory minimum requirement. This ratio demonstrated to stakeholders and the public that Wells Fargo maintains a strong capital buffer to absorb losses.3. Barclays: As part of its effort to strengthen its balance sheet, Barclays increased its CET1 ratio from 13.1% in 2016 to 13.3% in 2017. This increase was a result of reducing risk-weighted assets and increasing capital. Despite the bank’s operational troubles during that period, the improvement in the CET1 ratio gave investors more confidence in Barclay’s financial stability.

Frequently Asked Questions(FAQ)

What is Common Equity Tier 1 (CET1)?

Common Equity Tier 1 (CET1) measures a bank’s core equity capital against its total risk-weighted assets. It is incredibly significant because it is used to gauge a bank’s financial strength. CET1 capital includes ordinary shares, retained earnings, and other comprehensive income.

Why is CET1 important?

CET1 is important because it measures a bank’s financial strength. Authorities evaluate banks’ CET1 ratios to assess their ability to withstand financial distress. High CET1 denotes that a bank has sufficient capital to absorb losses without impacting its operations.

What is included in CET1 capital?

CET1 capital includes ordinary shares, retained earnings, and other comprehensive income. It may also include other reserves recognized by financial supervisory authorities.

What is the minimum CET1 ratio a bank should have?

As per Basel III accord, banks must have a CET1 ratio of at least 4.5%. However, post Basel III implementation, the minimum CET1 ratio requirement, includes a mandatory capital conservation buffer of 2.5%, effectively increasing the minimum CET1 requirement to 7%.

How is CET1 calculated?

The CET1 ratio is calculated by dividing a bank’s CET1 capital by its total risk-weighted assets. The result is commonly expressed as a percentage.

What happens if a bank’s CET1 ratio falls below the minimum required level?

If a bank’s CET1 ratio falls below the minimum level, it may be required to take corrective action, such as raising additional capital, reducing dividends, or limiting expansion of risk-weighted assets.

How does CET1 affect ordinary bank customers?

CET1 ratio can indirectly impact customers. If a bank with a low CET1 ratio fails, it might not be able to repay its depositors. Additionally, banks with healthy CET1 ratios might offer lower interest rates on loans as they are financially stable.

What is the difference between CET1 and Tier 1 Capital?

CET1 is the highest quality capital a bank possesses, including items like ordinary shares and retained earnings. Tier 1 capital, on the other hand, includes CET1 and additional Tier 1 capital (AT1). AT1 capital comprises instruments that are riskier and may be converted to CET1 in times of financial stress.

Related Finance Terms

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