Common Equity Tier 1 (CET1) capital ratio is a measure of a bank’s financial strength and ability to withstand financial stress. It is one of the components of the Basel III capital framework, which is a set of international standards for bank capital adequacy, stress testing, and liquidity risk management.
The CET1 capital ratio is calculated by dividing a bank’s CET1 capital by its risk-weighted assets (RWA). CET1 capital comprises the bank’s common equity and retained earnings, minus any deductions and regulatory adjustments. RWAs are calculated by assigning a risk weight to each asset on the bank’s balance sheet based on the risk associated with that asset.
The minimum CET1 capital ratio required under Basel III is 4.5%, but many banks aim to maintain a higher CET1 capital ratio to be seen as financially solid and stable. A typical target for banks is to maintain a CET1 capital ratio of at least 7% or 8%, although this can vary depending on the bank’s risk profile, regulatory requirements, and other factors.
It’s worth noting that the CET1 capital ratio is just one of several measures of a bank’s financial strength and ability to withstand stress. Other measures include the Tier 1 capital ratio, which includes other types of capital besides CET1 capital, and the leverage ratio, which measures a bank’s Tier 1 capital relative to its total assets.
Difference between CET1 capital ratio and Tier 1 capital ratio
Both Common Equity Tier 1 (CET1) capital ratio and Tier 1 capital ratio are measures of a bank’s capital adequacy, but they differ in their definitions of capital.
CET1 capital is a subset of Tier 1 capital and represents a bank’s highest-quality capital. It comprises a bank’s common equity and retained earnings, minus any deductions and regulatory adjustments. CET1 capital is considered the most loss-absorbing form of capital because it can absorb losses without triggering default or requiring government support.
Tier 1 capital, on the other hand, includes all of a bank’s CET1 capital plus other forms of Tier 1 capital, such as non-cumulative perpetual preferred stock and other regulatory capital instruments. Tier 1 capital is designed to absorb losses in the event of a bank’s financial distress and is considered the minimum capital requirement for a bank to remain viable.
The critical difference between the CET1 capital ratio and the Tier 1 capital ratio is the numerator. The CET1 capital ratio measures a bank’s CET1 capital as a percentage of its risk-weighted assets (RWAs), while the Tier 1 capital ratio measures a bank’s Tier 1 capital as a percentage of its RWAs.
Generally, a bank’s CET1 capital ratio will be higher than its Tier 1 capital ratio since CET1 capital is a subset of Tier 1 capital. As a result, regulators tend to focus more on the CET1 capital ratio as a measure of a bank’s capital adequacy and financial strength. However, both ratios are important and are used by investors, analysts, and regulators to assess a bank’s financial health and ability to withstand stress.
Example of CET1 capital ratio
Common Equity Tier 1 (CET1) capital is a component of a bank’s Tier 1 capital and includes the most basic and permanent types of common equity, such as common stock and retained earnings. Below is an example of how CET1 capital is calculated.
Assume a bank has the following metrics in its balance sheet:
- Common stock: $5 billion;
- Retained earnings: $3 billion;
- Accumulated other comprehensive income: $2 billion
- Additional Tier 1 (AT1) capital: $5 billion
- Tier 2 capital: $3 billion
- Risk-weighted assets (RWA): $100 billion
CET1 capital = Common stock + retained earnings + accumulated other comprehensive income = $5 billion + $3 billion + $2 billion = $10 billion
In this example, the bank’s CET1 capital is $10 billion, which represents a portion of the bank’s overall Tier 1 capital. This capital is considered the most loss-absorbing component of the bank’s capital structure, as it can be used to absorb losses before any other type of capital. Note that CET1 capital excludes any other type of capital, such as preferred shares or debt.
CET1 capital ratio = CET1 capital / RWA = $10 billion / $100 billion = 0.10 or 10%
So in this example, the CET1 capital ratio for the bank is 10%. This means that for every $100 of risk-weighted assets on its balance sheet, the bank has $10 of CET1 capital to absorb losses before dipping into its AT1 or Tier 2 capital.
Related information
Refer to the related knowledge resources:
- An introduction to assessing the financial strength of banks
- An introduction to fractional reserve banking
- An introduction to discount window borrowing
- An introduction to bank bailout
- An introduction to bank bail-in
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