Definition and Methodology for Common Equity Tier 1 (CET1) Computation

A essential component of a bank's capital structure, the Common Equity Tier 1 (CET1) serves to safeguard the economy by absorbing losses as they occur, thus protecting depositors.

Grasping Common Equity Tier 1 (CET1)

A critical portion of Tier 1 capital, CET1 primarily encompasses the common stock owned by a bank or other financial institution. Introduced in 2014 as a preventative measure following the 2007-2008 financial crisis, the CET1 ratio determines a bank's capital strength by comparing its capital to its assets.

Crucial Takeaways

CET1 covers liquid bank holdings such as cash and stock.
The CET1 ratio compares a bank's capital against its assets.
Additional Tier 1 (AT1) capital consists of instruments that are not common equity.
In times of crisis, equity is withdrawn first from Tier 1.
Many stress tests use Tier 1 capital as a starting point to gauge a bank's liquidity and ability to survive a challenging economic event.

Insights into Common Equity Tier 1 (CET1)

In an effort to review and monitor banks' capital adequacy following the significant financial crisis, the Basel Committee established a reformed set of international standards, collectively known as Basel III. These standards assess a bank's assets against its capital to ensure the bank can endure a financial crisis.

Capital is essential for a bank to absorb unexpected losses during regular operations. The Basel III framework heightens capital requirements by limiting the types of capital a bank may include in its different capital tiers and structures.

A bank's capital structure consists of several tiers:

Tier 1 Capital: Known as going concern or core capital, Tier 1 is used to finance a financial institution's business activities and is divided into CET1 and Additional Tier 1 (AT1) capital.
Tier 2 Capital: Often called gone concern or supplementary capital, this category includes hybrid capital instruments and subordinated term debt.
Tier 3 Capital: This lowest quality type of capital encompasses market risk, commodities risk, and foreign currency risk.

CET1 is defined as the highest quality regulatory capital, as it immediately absorbs losses when they occur[1]. A bank's Tier 1 capital must include a minimum ratio of 4.5% of CET1 to its risk-weighted assets (RWAs)[5].

Additional Considerations

Should a bank experience losses during a crisis, these losses are first deducted from the Tier 1 capital, with CET1 situated at the bottom of the capital structure. If this deduction causes the CET1 ratio to drop below its regulatory minimum, the bank must raise its capital ratio back to acceptable levels to avoid potential regulatory intervention[4].

During the rebuilding phase, regulators may prevent the bank from issuing dividends or bonuses to employees. In cases of insolvency, the equity holders are the first to bear the losses[6].

Stress Tests

Regulators conduct periodic stress tests using the Tier 1 capital and CET1 ratios to evaluate a bank's liquidity and ability to withstand a crisis. The results of these tests have indicated that most banks can survive a crisis[8].

Computing the CET1 Capital Ratio

Tier 1 capital is calculated as Common Equity Tier 1 capital plus Additional Tier 1 capital. CET1 consists of a bank's core capital, including common shares, share premiums, retained earnings, qualifying minority interest, and other comprehensive income[4].

Additional Tier 1 capital encompasses instruments that are not common equity but are eligible for inclusion in this tier. An example of AT1 capital is a contingent convertible or hybrid security, which can be converted into equity during a trigger event when CET1 capital falls below a specific threshold[4].

The CET1 ratio measures a bank's capital against its assets, with assets weighted based on their associated credit risk and market risk[9].

Explaining CET1 Like You're 5

Banks operate by holding assets and managing liabilities, resulting in balance sheets that list these assets and liabilities. By subtracting total liabilities from total assets, we find the bank's capital, which are the investments made by its shareholders.

This capital is divided into two categories: Tier 1 and Tier 2. Tier 1 capital is further divided into Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1) capital. CET1, composed of common shares, share premiums, retained earnings, and regulatory adjustments, works alongside AT1 to absorb losses during a bank's normal operations[10].

Differentiation between Tier 1 Capital and CET1 Capital

CET1 capital makes up one component of total Tier 1 capital, with Additional Tier 1 capital (AT1) being the other[3]. The equation AT1 + CET1 = Tier 1 capital.

The Required Minimum Tier 1 Capital for a Bank

The Basel Accords establish the minimum capital requirements for banks, which must maintain a Tier 1 capital ratio of at least 8%, with 6% of this being Tier 1 capital[4].

Implications of a Low CET1 Ratio

A low CET1 ratio indicates an insufficient level of Tier 1 capital, potentially preventing a bank from absorbing a financial shock. Worldwide, regulators stress-test banks to ensure they can handle these shocks, with the CET1 ratio being one of the key metrics in these tests[7].

The Final Word

Common Equity Tier 1 (CET1) is a crucial component of a bank's capital structure, serving as the highest quality and most loss-absorbing form of regulatory capital during normal operations and financial crises. Banks are expected to maintain a minimum CET1 ratio as outlined by regulatory bodies[1][3]. Should losses occur, these are first deducted from the CET1, ensuring a bank's solvency and operational continuity[2][5].

The Deanonymized Finance (DeFi) industry has shown interest in implementing Common Equity Tier 1 (CET1) as a standard for tokenized assets, mirroring the traditional banking sector's focus on capital strength.
As the digital asset market continues to grow, private equity firms are exploring the possibility of investing in DeFi projects, seeking high-yield tokens that meet CET1 regulations as part of a diverse investment portfolio in the finance and business sectors.
Some analysts predict that the convergence of traditional banking and DeFi, while still challenging due to regulatory hurdles, could lead to increased liquidity and improved risk management for both sectors, using CET1 as a benchmark for stability.
In a future where decentralized banking and insurance services (DeFi-insurance) become more widely adopted, the implementation of CET1 could ensure that users' funds are safeguarded, fostering trust and confidence in the DeFi and global finance industries alike.