Common Equity Tier 1 (CET1)

Common Equity Tier 1 (CET1) is the core component of a bank's regulatory capital. It consists of the funds that belong to ordinary shareholders, chiefly paid-in share capital and accumulated profits, reduced by a set of regulatory deductions. Because it has no maturity, carries no obligation to pay dividends and absorbs losses as soon as they arise, CET1 is regarded as the capital best able to keep a bank solvent while it continues to operate.

The definition was introduced by the Basel Committee on Banking Supervision in Basel III, after the financial crisis of 2007 to 2009 showed that many banks had reported adequate capital while holding very little true equity. CET1 forms Tier 1 capital together with Additional Tier 1 capital (AT1), and Tier 1 plus Tier 2 capital makes up total capital. The CET1 ratio is the measure of bank strength most closely watched by supervisors, investors and rating agencies.

The qualifying items are:

• Ordinary shares issued by the bank that meet criteria for permanence, full subordination and discretionary dividends, together with the related share premium.
• Retained earnings, including profit for the period once verified.
• Accumulated other comprehensive income and other disclosed reserves.
• Certain minority interests in consolidated banking subsidiaries, within limits.

From this total, regulatory adjustments are made so that only capital genuinely available to absorb losses is counted. The principal deductions are goodwill and other intangible assets; any deferred tax asset whose value depends on future profits; holdings of the bank's own shares; a shortfall of accounting provisions against expected losses for banks using internal models; surpluses in defined benefit pension funds; and significant investments in other financial institutions above set thresholds. Gains arising from a fall in the bank's own credit standing are also removed.

The standard calculation is:

• CET1 capital is the amount after deductions.
• Risk-weighted assets are the bank's exposures weighted for credit, market and operational risk; see risk-weighted assets (RWA).

A bank with CET1 capital of 12 billion and risk-weighted assets of 100 billion has a CET1 ratio of 12%. The ratio rises if the bank retains profit or issues shares, and falls if it makes losses, pays dividends, carries out a share buyback or increases its risk-weighted assets.

Basel III sets a minimum CET1 ratio of 4.5%, within a Tier 1 minimum of 6% and a total capital minimum of 8%. These form the Pillar 1 capital requirement. On top of the minimum sit buffers that must be met entirely with CET1. The capital conservation buffer of 2.5% applies to all banks. The countercyclical buffer, set by national authorities, generally ranges from zero to 2.5% and is raised when credit is growing rapidly. Surcharges apply to systemically important banks, and some jurisdictions add a systemic risk buffer.

Supervisors also impose bank-specific add-ons through the Pillar 2 capital requirement. In the United States, large banks hold a stress capital buffer derived from annual stress tests, with a floor of 2.5%. As a result, large banks typically face an effective CET1 requirement of 10% or more and choose to hold a margin above it.

A bank that dips into its buffers is not in breach of the minimum, but it faces automatic limits on dividends, share buybacks, bonus payments and coupons on AT1 instruments until the buffer is rebuilt. This is intended to conserve capital early.

CET1 is the first capital to absorb losses and the only capital that does so without any trigger or decision. A loss reduces retained earnings directly. Other instruments absorb losses only on conversion, write-down or failure. For this reason, market confidence in a bank depends heavily on its CET1 ratio and on the distance between that ratio and the point at which distribution limits apply.

The ratio also drives business decisions. Since equity is the most expensive form of funding, banks allocate CET1 to business lines and expect each to earn an adequate return on it. Activities with high risk weights consume more CET1 and must generate more profit to justify themselves. Capital planning sets a target ratio, a dividend policy and a path for growth in risk-weighted assets that are consistent with one another.

The CET1 ratio is only as reliable as its denominator. Risk weights, particularly those produced by banks' own models, have varied widely between banks for similar exposures. The final Basel III reforms respond with an output floor that limits how far modelled risk weights can fall below the standardised approach. The leverage ratio, which compares Tier 1 capital with total exposure regardless of risk, acts as a backstop.

The numerator has weaknesses as well. Accounting rules determine when losses are recognised: fixed-rate securities carried at amortised cost do not reduce CET1 when interest rates rise, even though their market value has fallen, and in some jurisdictions smaller banks may exclude unrealised losses on other securities. Provisions under the expected credit loss (ECL) model affect CET1 through profit, and transitional arrangements softened their initial impact. Comparisons between banks and across countries therefore require attention to how each figure was produced, and to related measures such as the total capital ratio.

• Basel Committee on Banking Supervision