Table of Contents
- What Is Common Equity Tier 1 (CET1)?
- Understanding Common Equity Tier 1 (CET1)
- Special Considerations
- Stress Tests
- Calculating the CET1 Capital Ratio
- Explain CET1 Like I'm 5
- How Are Tier 1 Capital and CET1 Capital Different?
- What Is the Minimum Tier 1 Capital a Bank Can Have?
- What Does a Low CET1 Ratio Mean?
- The Bottom Line
What Is Common Equity Tier 1 (CET1)?
Let me explain Common Equity Tier 1, or CET1, directly to you. It's a key part of Tier 1 capital in a bank's structure, mainly made up of common stock that the bank or financial institution holds. CET1 came into play in 2014 as a safeguard to shield the economy from financial crises. As a bank, you're required to hit the minimum CET1 ratio set by your regulators—it's non-negotiable.
Key Takeaways
- CET1 includes liquid holdings like cash and stock.
- The CET1 ratio measures a bank's capital against its assets.
- Additional Tier 1 (AT1) capital consists of non-common equity instruments.
- In a crisis, losses hit Tier 1 equity first.
- Stress tests often start with Tier 1 capital to evaluate a bank's liquidity and survival in tough economic scenarios.
Understanding Common Equity Tier 1 (CET1)
After the 2007-2008 financial crisis, the Basel Committee rolled out Basel III standards to check and monitor banks' capital adequacy. These rules compare a bank's assets to its capital to see if it can handle a crisis. You need to know that banks hold capital to cover unexpected losses from regular operations. Basel III tightens this by restricting what counts in different capital tiers.
A bank's capital breaks down into tiers. Tier 1, or going concern capital, funds the bank's activities and includes CET1 and AT1. Tier 2 is supplementary, or gone concern capital, with things like hybrid instruments and subordinated debt. Tier 3, the lowest quality, covers risks like market, commodities, and foreign currency.
CET1 stands out as the top-quality regulatory capital because it absorbs losses right away, per the Bank for International Settlements. Your bank's Tier 1 must have at least 4.5% CET1 relative to risk-weighted assets (RWAs). CET1 measures solvency and gauges capital strength—it's crucial.
Special Considerations
In a bank's capital setup, you have Lower Tier 2, Upper Tier 1, AT1, and CET1 at the base. That means in a crisis, losses come out of CET1 first. If that drops your CET1 ratio below the minimum, you have to rebuild it, or regulators might step in and shut things down.
While rebuilding, expect restrictions—no dividends or bonuses. If insolvency hits, equity holders take the first losses.
Stress Tests
The European Banking Authority runs stress tests on CET1 ratios periodically to figure out how much capital banks would have left in a crisis. From what we've seen, most banks come out able to survive.
Calculating the CET1 Capital Ratio
Tier 1 capital is CET1 plus AT1. CET1 includes common shares, stock surpluses from issuing them, retained earnings, shares from subsidiaries held by others, and accumulated other comprehensive income (AOCI). AT1 covers non-common equity instruments eligible for this tier, like contingent convertibles or hybrids that convert to equity if CET1 drops below a threshold.
The CET1 ratio is CET1 capital divided by risk-weighted assets. Assets get weighted by risk—not all are equal. A government bond might be zero-risk, while a subprime mortgage could be 65%. Basel III requires at least 4.5% CET1 to RWAs.
Explain CET1 Like I'm 5
Banks are like businesses with assets and liabilities on a balance sheet. Subtract liabilities from assets, and you get capital from shareholders. This splits into Tier 1 and Tier 2. Tier 1 has CET1 and AT1. CET1, from common shares, surpluses, earnings, minority interests, and other income, absorbs losses in normal operations along with AT1.
How Are Tier 1 Capital and CET1 Capital Different?
CET1 is just one piece of total Tier 1 capital. The other is AT1. So, AT1 plus CET1 equals Tier 1.
What Is the Minimum Tier 1 Capital a Bank Can Have?
Under the Basel Accords, banks need a minimum 8% capital ratio, with 6% as Tier 1.
What Does a Low CET1 Ratio Mean?
A low CET1 ratio signals weak Tier 1 capital, which might not handle a financial hit. Regulators stress-test banks globally using CET1 to confirm they can manage shocks.
The Bottom Line
CET1 is part of Tier 1 capital, covering holdings like cash and stock. It's the best regulatory capital, and banks must meet minimum CET1 ratios from regulators. In a crisis, losses deduct from CET1 first.
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