Tier 1 capital is a bank’s core capital. This consists of common stock and disclosed reserves (retained earnings).
Financial regulators use Tier 1 capital as a means of measuring a bank’s solvency, i.e. it is the core measure of the financial strength of a bank, from a regulator’s point of view. This measure is seen as more reliable than Tier 2 capital.
Tier 1 capital is defined in the Basel Accords, which are created by the Basel Committee on Banking Supervision (BCBS) – the global governing body on banking regulation and supervision.
The Basel III accord states that the “predominant form of Tier 1 capital must be common shares and retained earnings.”
Adding that “the remainder of the Tier 1 capital base must be comprised of instruments that are subordinated, have fully discretionary non-cumulative dividends or coupons and have neither a maturity date nor an incentive to redeem.”
Tier 1 capital is the sum of the following:
– Common shares the bank has issued that meet the criteria for classification as common shares for regulatory purposes (or the equivalent for non-joint stock companies).
– Stock surplus (share premium) resulting from the issue of instruments including Common Equity Tier 1.
– Retained earnings (sometimes called ‘plowback’ – the companies cumulative earnings after paying dividends, since it started doing business).
– Accumulated other comprehensive income and other disclosed reserves.
– Common shares issued by consolidated subsidiaries of the bank and held by third parties (ie minority interest) that meet the criteria for inclusion in Common Equity Tier 1 capital.
– Regulatory adjustments applied in the calculation of Common Equity Tier 1.
Additional Tier 1 capital is the sum of the following:
– Instruments issued the bank issued that meet the criteria for inclusion in Additional Tier 1 capital (but are not included in Common Equity Tier 1).
Stock surplus (share premium) resulting from the issue of instruments included in Additional Tier 1 capital.
Instruments issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in Additional Tier 1 capital and are not included in Common Equity Tier 1.
Regulatory adjustments applied in the calculation of Additional Tier 1 Capital.
Video – Tier 1 Capital