What is Common Equity Tier 1 (CET1)?
– Common Equity Tier 1 (CET1) is the highest-quality form of a bank’s regulatory capital. In plain terms, it is the core equity that belongs to shareholders (common stock and retained earnings, plus a few other permitted items). Regulators count CET1 first when a bank needs to absorb losses.
Why CET1 matters
– CET1 is a solvency measure: it shows how much top-quality capital a bank has relative to the riskiness of its assets. Regulators use CET1 to decide whether a bank can withstand financial stress without endangering depositors or the financial system.
Key definitions
– Tier 1 capital: The primary capital base for a bank. It equals CET1 plus Additional Tier 1 (AT1) capital.
– Additional Tier 1 (AT1) capital: Instruments that are not common equity but can absorb losses; examples include contingent convertible (CoCo) bonds that can be written down or converted to equity if triggers are hit.
– Risk-weighted assets (RWAs): Bank assets adjusted by risk weights to reflect credit and market risk. Safer assets receive lower weights (a government bond can be zero-weighted); higher-risk assets receive larger weights (for example, a subprime mortgage might carry a 65% weight in some frameworks).
– CET1 ratio: CET1 capital divided by RWAs, usually presented as a percentage:
CET1 ratio = (CET1 capital / Risk-weighted assets) × 100%
Regulatory minima (as established under Basel III standards described by global regulators)
– Minimum CET1 ratio: 4.5% of RWAs.
– Minimum Tier 1 capital: 6% of RWAs (CET1 + AT1).
– Minimum total capital (Tier 1 + Tier 2): 8% of RWAs.
Note: These are baseline minima used by the Basel framework; national regulators may add buffers or higher effective requirements.
How CET1 absorbs losses
– Because CET1 is the highest-quality equity, losses are first deducted from CET1. If losses reduce CET1 below required levels, regulators typically require the bank to rebuild capital and may restrict dividends and bonuses until restoration is complete. In severe cases, regulators can place the bank under resolution or close it.
Difference between CET1 and Tier 1
– CET1 is core common equity. Tier 1 equals CET1 + AT1. AT1 instruments sit above subordinated debt but below CET1 in loss-absorption hierarchy. AT1 can be useful for capital but is not
as loss-absorbing as CET1 because AT1 is contractual and can be written down or converted into common equity only when predefined triggers are hit. That makes CET1 the first and cleanest buffer regulators and creditors rely on in a stress event.
How CET1 is measured
– Core definition: The CET1 ratio = CET1 capital / risk-weighted assets (RWAs).
– CET1 capital (numerator) typically includes:
– Ordinary common shares issued and fully paid.
– Retained earnings (accumulated undistributed profits).
– Accumulated other comprehensive income (AOCI), subject to regulatory rules.
– Certain minority interests and other prudentially allowed items.
– Minus regulatory deductions and adjustments such as goodwill and other intangibles, foreseeable distributions, own shares, significant investments in financial institutions, and certain deferred tax assets (subject to recognition rules).
– RWAs (denominator) are the bank’s assets weighted by risk according to regulatory rules; higher-risk assets carry larger weights.
Worked numeric example
– Suppose a bank reports:
– Common equity (ordinary shares): $10.0 billion
– Retained earnings: $5.0 billion
– AOCI (net): $1.0 billion
– Deductions: goodwill $2.0 billion, intangible software $0.5 billion
– RWAs: $120.0 billion
– CET1 capital = 10.0 + 5.0 + 1.0 − 2.0 − 0.5 = $13.5 billion
– CET1 ratio = 13.5 / 120.0 = 0.1125 = 11.25%
Regulatory minima and buffers (typical)
– Basel III minimum CET1 ratio: 4.5% of RWAs.
– Capital conservation buffer: +2.5% (aims to preserve a minimum level of usable capital).
– Countercyclical buffer: 0%–2.5% (set by national authorities depending on systemic risk).
– Additional buffers: G-SIB (global systemically important bank) surcharges, domestic counterparty surcharges, or other national add-ons.
– Effective minimums are therefore higher than 4.5% in most jurisdictions once buffers and surcharges are included.
What happens if CET1 falls
– Losses are absorbed from CET1 first. If a bank’s CET1 ratio falls below regulatory thresholds, supervisors typically:
– Require capital restoration plans.
– Limit dividends, share buybacks, and discretionary bonuses to conserve capital.
– Increase supervision intensity and, in severe cases, use resolution powers or require recapitalization.
– AT1 and Tier 2 instruments can absorb losses only under their contractual terms and after CET1 is depleted to trigger levels.
Practical checklist for analyzing a bank’s CET1 strength
1. Read the bank’s regulatory capital table (Pillar 3 / financial statements) to get the reported CET1 ratio and composition.
2. Check which items were deducted or adjusted (goodwill, DTAs, minority interests).
3. Confirm the RWA methodology (standardized vs. internal models); internally modelled RWAs can materially differ.
4. Add applicable buffers: conservation buffer, countercyclical buffer, and any G-SIB surcharge.
5. Look at trend and volatility: is CET1 rising, stable, or declining across quarters/years?
6. Compare CET1 to peers and to the bank’s stated risk appetite and supervisory requirements.
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