What is Tier 1 Capital? - Definition, Ratio & Core Capital

Instructor: Michelle Reichartz

In this lesson, you will learn what Tier 1 capital stands for, what assets are included, how to calculate the required ratio, and its importance in how banks function.

Protecting Against Worst-Case Scenarios

Everybody thinks about the 'what ifs' in life: the emergencies, the accidents, the worst-case scenarios. Some of us even do the best we can to try to be prepared if any of those situations come to life. After all, no one likes to be blindsided by a disaster and completely unprepared to handle it, right?

This same premise follows for banks. After the financial crises the United States has seen, it's important that our financial institutions are prepared for the next unforeseen situation. In the spirit of this concern, Tier 1 capital exists.

Defining Tier 1 Capital

Tier 1 capital is the core capital a bank holds in its reserves and exists as the primary source of funds. It's the assets a bank holds in order to continue providing for the business needs of its customers. Since banks typically provide capital for customers, this can include a substantial amount of risk. The capital held helps to ensure there is enough money to fulfill needs.

Tier 1 capital includes common stock, retained earnings, and preferred stock. The amount of capital that is held shows the strength of that bank as a measure of financial preparedness in case of emergencies.

Tier 1 Capital Ratio

The strength of those banks is defined based on what is called the Tier 1 capital ratio. This is the formula utilized to describe the capital being held versus what's known as total risk-weighted assets (RWAs). Risk-weighted assets are the assets held by the bank that are weighted by its credit risk.

The result of the formula is a percentage. The acceptable amount of Tier 1 capital held by a bank is at least 6%.

The formula is core capital divided by risk-weighted assets multiplied by 100 to get the final percentage.

Let's look at an example. Bank ABC has \$300 in core capital. They've lent a total of \$5,000 with a risk weight at 75%.

The calculation for their Tier 1 capital ratio would be as follows:

Core Capital: \$300

divided by

Risk-Weighted Capital: \$5,000 multiplied by 75% = \$3,750

multiplied by 100

In this example, our final Tier 1 capital ratio is 8%. Since the minimum required is 6%, bank ABC is meeting their required minimum percentage.

There is an additional formula known as the Tier 1 common capital ratio. It follows the same formula, but only includes the common stock, retained earnings, and other comprehensive income in the ratio. Of the minimum required 6% that a bank must hold, 4.5% of it must come from common stock, retained earnings, and other comprehensive income.

Let's look back again at our bank ABC example. Bank ABC has \$300 in core capital, \$150 of which is common stock. They've lent a total of \$5,000 with a risk weight at 75%.

The calculation for their Tier 1 common capital ratio would be as follows:

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