Tier 1 Capital

Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital, which consists primarily of common stock and disclosed reserves (or retained earnings), but may also include non-redeemable non-cumulative preferred stock. The Basel Committee also observed that banks have used innovative instruments over the years to generate Tier 1 capital; these are subject to stringent conditions and are limited to a maximum of 15% of total Tier 1 capital.

Capital in this sense is related to, but different from, the accounting concept of shareholders' equity. Both Tier 1 and Tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord. Tier 2 capital represents "supplementary capital" such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt.

Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems.

The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses, which are covered by provisions, reserves and current year profits. In Basel I agreement, Tier 1 capital is a minimum of 4% ownership equity but investors generally require a ratio of 10%. Tier 1 capital should be greater than 150% of the minimum requirement.