Common Equity Tier 1 (CET1) capital represents the most robust form of capital held by banking institutions. Primarily composed of ordinary shares and accumulated earnings, CET1 acts as an essential safeguard against financial downturns. Its introduction in 2014, under the Basel III framework, aimed to fortify the global financial system following the 2007–2008 crisis. Banks are mandated to uphold minimum CET1 ratios, as stipulated by financial regulators, to ensure their capacity to absorb losses.
The Basel Committee established a revised set of international guidelines to assess and supervise banks' capital adequacy in response to the 2007–2008 financial turmoil. These regulations, collectively known as Basel III, evaluate a bank's resilience to economic crises by comparing its assets against its capital. The framework imposes stricter capital requirements by limiting the types of capital that can be included in various capital tiers.
Banks are required to maintain capital to absorb unforeseen losses arising from their operational activities. The Basel III framework refines capital requirements by restricting the types of capital that banks can classify within their different tiers and structures. A bank's capital framework includes several tiers. Tier 1 Capital, or core capital, supports a financial institution's business operations and comprises Common Equity Tier 1 (CET1) and Additional Tier 1 (AT1) capital. Tier 2 Capital, also known as supplementary capital, consists of instruments like hybrid capital and subordinated debt. Tier 3 Capital covers market risk, commodities risk, and foreign currency risk, representing the lowest quality of the three tiers.
Common Equity Tier 1 is considered the 'highest quality of regulatory capital, as it absorbs losses immediately when they occur,' according to the Bank for International Settlements. Banks are required to maintain a minimum CET1 ratio of 4.5% relative to their risk-weighted assets (RWAs). The European Banking Authority periodically conducts stress tests, utilizing the CET1 ratio, to determine how much capital banks would retain during adverse financial crises. These tests have generally indicated that most banks possess sufficient capital to withstand such events.
A bank's capital structure is layered, with CET1 at the base, meaning that any losses incurred during a crisis are first deducted from this tier. If the deduction causes the CET1 ratio to fall below the regulatory minimum, the bank must recapitalize to the required level or face intervention or closure by regulators. During such rebuilding phases, regulators may restrict the bank from issuing dividends or employee bonuses. In the event of insolvency, equity holders are the first to bear the losses.
The CET1 ratio is determined by dividing Common Equity Tier 1 Capital by Risk-Weighted Assets. CET1 itself includes common shares, stock surpluses from common share issuance, retained earnings, qualifying minority interests, and accumulated other comprehensive income (AOCI). Additional Tier 1 capital, on the other hand, consists of instruments not classified as common equity but eligible for inclusion in this tier, such as contingent convertible securities. These securities convert to equity if CET1 capital drops below a specific threshold. This ratio effectively measures a bank's capital strength against its asset base, with assets weighted according to their credit and market risk. For instance, a government bond might have a zero percent risk weighting, while a subprime mortgage could be weighted at 65%. Basel III regulations mandate that all banks maintain a minimum CET1 to RWAs ratio of 4.5%.
Common Equity Tier 1 (CET1) is the most critical component of a bank's capital structure, providing the primary defense against financial shocks. By maintaining stringent CET1 ratios, banks ensure their resilience and contribute to the stability of the global financial system, protecting depositors and the broader economy from potential crises. This emphasis on high-quality capital reflects a fundamental shift towards a more robust and responsive banking sector.