Tier 1 Capital Ratio Definition

The tier 1 capital ratio is the ratio of a bank’s core tier 1 capital—that is, its equity capital and disclosed reserves—to its total risk-weighted assets. It is a key measure of a bank's financial strength that has been adopted as part of the Basel III Accord on bank regulation.

The tier 1 capital ratio measures a bank’s core equity capital against its total risk-weighted assets—which include all the assets the bank holds that are systematically weighted for credit risk. For example, a bank’s cash on hand and government securities would receive a weighting of 0%, while its mortgage loans would be assigned a 50% weighting.

Tier 1 capital is core capital and is comprised of a bank's common stock, retained earnings, accumulated other comprehensive income (AOCI), noncumulative perpetual preferred stock and any regulatory adjustments to those accounts.

$\text{Tier 1 Capital Ratio} = \frac{\text{Tier 1 Capital}}{\text{Total Risk Weighted Assets}}$Tier 1 Capital Ratio=Total Risk Weighted AssetsTier 1 Capital​

The tier 1 capital ratio is the basis for the Basel III international capital and liquidity standards devised after the financial crisis, in 2010. The crisis showed that many banks had too little capital to absorb losses or remain liquid, and were funded with too much debt and not enough equity.

To force banks to increase capital buffers, and ensure they can withstand financial distress before they become insolvent, Basel III rules would tighten both tier 1 capital and risk-weighted assets (RWAs). The equity component of tier-1 capital has to have at least 4.5% of RWAs. The tier 1 capital ratio has to be at least 6%.

Basel III also introduced a minimum leverage ratio—with tier 1 capital, it must be at least 3% of the total assets—and more for global systemically important banks that are too big to fail. The Basel III rules have yet to be finalized due to an impasse between the U.S. and Europe.

A firm's risk-weighted assets include all assets that the firm holds that are systematically weighted for credit risk. Central banks typically develop the weighting scale for different asset classes; cash and government securities carry zero risk, while a mortgage loan or car loan would carry more risk. The risk-weighted assets would be assigned an increasing weight according to their credit risk. Cash would have a weight of 0%, while loans of increasing credit risk would carry weights of 20%, 50% or 100%.

The tier 1 capital ratio differs slightly from the tier 1 common capital ratio. Tier 1 capital includes the sum of a bank's equity capital, its disclosed reserves, and non-redeemable, non-cumulative preferred stock. Tier 1 common capital, however, excludes all types of preferred stock as well as non-controlling interests. Tier 1 common capital includes the firm's common stock, retained earnings and other comprehensive income.

For related insight, read more about Basel III international regulations.

For example, assume that bank ABC has shareholders' equity of $3 million and retained earnings of $2 million, so its tier 1 capital is $5 million. Bank ABC has risk-weighted assets of $50 million. Consequently, its tier 1 capital ratio is 10% ($5 million/$50 million), and it is considered to be well-capitalized compared to the minimum requirement.

On the other hand, bank DEF has retained earnings of $600,000 and stockholders' equity of $400,000. Thus, its tier 1 capital is $1 million. Bank DEF has risk-weighted assets of $25 million. Therefore, bank DEF's tier 1 capital ratio is 4% ($1 million/$25 million), which is undercapitalized because it is below the minimum tier 1 capital ratio under Basel III.

Bank GHI has tier 1 capital of $5 million and risk-weighted assets of $83.33 million. Consequently, bank GHI's tier 1 capital ratio is 6% ($5 million/$83.33 million), which is considered to be adequately capitalized because it is equal to the minimum tier 1 capital ratio.

The tier 1 leverage ratio is the relationship between a banking organization's core capital and its total assets. The tier 1 leverage ratio is calculated by dividing tier 1 capital by a bank's average total consolidated assets and certain off-balance sheet exposures. Similarly to the tier 1 capital ratio, the tier 1 leverage ratio is used as a tool by central monetary authorities to ensure the capital adequacy of banks and to place constraints on the degree to which a financial company can leverage its capital base but does not use risk-weighted assets in the denominator.