Tier 1 Capital

Definition

Tier 1 capital refers to the core capital of a bank, which includes its equity capital and disclosed reserves. It essentially represents the financial strength of a bank and its ability to absorb losses. This capital is used in the calculation of a bank’s capital adequacy ratios, helping regulatory authorities assess a bank’s financial stability.

Phonetic

The phonetics of the keyword “Tier 1 Capital” is: /ˈtɪər wʌn ˈkæpɪtl/

Key Takeaways

1. Definition: Tier 1 Capital is the core capital that a bank uses to absorb losses without ceasing business operations. It is essentially a measure of a bank’s financial strength from a regulator’s perspective.
2. Components: It predominantly consists of shareholders’ equity and retained earnings. This includes common stock, declared reserves, and other instruments that are fully loss-absorbent.
3. Importance: The adequacy of Tier 1 Capital is crucial for a bank. It is used as a buffer against unexpected financial crises, portraying the financial health of a bank. The Tier 1 Capital ratio, which measures this capital against a bank’s total risk-weighted assets, is an important indication of a bank’s ability to withstand economic downturns.

Importance

Tier 1 Capital is crucial in the business/finance sector as it represents the core measure of a bank’s financial strength from a regulator’s point of view. It is an essential component of the capital requirement that ensures a bank’s ability to absorb losses without failing, placing it literally at the first line of financial defense. It consists of the most solid types of capital, such as common stock, declared reserves, and retained earnings, thus providing a consistent and reliable barometer of a bank’s liquidity, financial stability, and capacity to meet its financial obligations. Its level can act as an indicator of a bank’s resilience in the face of financial adversities, providing a benchmark for both regulators and market Participants.

Explanation

Tier 1 capital serves a very critical role in the banking sector, functioning as the primary source of financial strength and resilience for a bank against risk-related losses. Essentially, it acts as a buffer, providing financial protection against unforeseen events that could otherwise seriously compromise the bank’s stability or even drive it into bankruptcy. It’s considered to be the most reliable and readily available form of capital, that can be used to absorb losses without a bank being required to cease its operations. Its high quality and liquidity is such that it can be quickly deployed to offset losses, thereby maintaining a bank’s solvency and preventing economic distress that can cause widespread disruptions in the financial system. Tier 1 capital is mainly used for two things: risk weighting and leverage. With regards to risk weighting, banks use Tier 1 capital to meet the minimum capital ratios set by regulatory bodies like the Bank for International Settlements (BIS). These capital ratios, which require banks to hold a certain level of Tier 1 capital relative to their risk-weighted assets, are intended to ensure that banks have enough financial buffer to absorb a certain level of losses. On the leverage side, Tier 1 capital is used to meet leverage ratios, which are regulatory requirements to establish a minimum level of capital against the total leverage exposure of a bank. Tier 1 capital requirements are thus part and parcel of the regulatory framework aimed at enhancing the overall stability and health of the global financial system.

Examples

1. JPMorgan Chase & Co.: It is one of the largest banking institutions in America. As per the financial reports of 2020, the bank reported a Tier 1 capital ratio of 13.1%, significantly above the regulatory minimum, reflecting the high quality of its capital resources. The bank’s Tier 1 capital includes its common equity and eligible preferred stock.2. Deutsche Bank AG: The German multinational bank, as of its financial statements of 2020, had a Tier 1 Capital Ratio of 13.6%. In Deutsche Bank’s case, its Tier 1 capital consists mainly of ordinary shares and retained earnings.3. HSBC Holdings PLC: This renowned bank based in Britain had a Tier 1 capital ratio of 15.9% as per its 2020 annual report. The Tier 1 capital of HSBC consists of the bank’s ordinary shares, retained earnings, and other reserves, which indicates a higher capacity to absorb potential losses.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Common Equity
• Risk-Weighted Assets
• Capital Adequacy Ratio (CAR)
• Basel III
• Core Capital

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Bankrate
• The Balance