Tier 1 Capital - Tier 1 Capital Ratio

Tier 1 Capital Ratio

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by the Regulator (usually the country's central bank). Most central banks follow the Basel Committee on Banking Supervision (BCBS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while certain loans have a risk weight at 100% of their face value. The BCBS is a part of the Bank of International Settlements (BIS). Under BCBS guidelines total RWA is not limited to Credit Risk. It contains components for Market Risk (typically based on value at risk (VAR) ) and Operational Risk. The BCBS rules for calculation of the components of total RWA have seen a number of changes following the Financial Crisis.

As an example, assume a bank with $2 of equity receives a client deposit of $10 and lends out all $10. Assuming that the loan, now a $10 asset on the bank's balance sheet, carries a risk weighting of 90%, the bank now holds risk-weighted assets of $9 ($10*90%). Using the original equity of $2, the bank's Tier 1 ratio is calculated to be $2/$9 or 22%.

There are two different conventions for calculating and quoting the Tier 1 capital ratio:

• Tier 1 common capital ratio and
• Tier 1 total capital ratio

Preferred shares and non-controlling interests are included in the Tier 1 total capital ratio but not the Tier 1 common ratio. As a result, the common ratio will always be less than or equal to the total capital ratio. In the example above, the two ratios are the same.