tier 1 capital

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Tier 1 capital

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Tier 1 capital is the core measure of abank's financial strength from a regulator's point of view. Itis composed ofcore capital,[1] which consists primarily ofcommon stockand disclosed reserves(orretained earnings),[2] but may also include non-redeemable non-cumulativepreferred stock.

Capital in this sense is related to, but different from, the accounting concept ofshareholders'equity. Both Tier 1 andTier 2 capital were first defined in theBasel Icapital accord and remainedsubstantially the same in the replacementBasel II accord.Tier 2 capitalis senior to Tier 1, butsubordinate to deposits and the deposit insurer's claims. These include preferred stock with fixedmaturities and long-term debt with minimum maturities of over five years.

Each country's banking regulator, however, has some discretion over how differingfinancialinstruments may count in a capital calculation. This is appropriate, as the legal framework varies indifferent legal systems.

The theoretical reason for holding capital is that it should provide protection against unexpectedlosses. Note that this is not the same as expected losses, which are covered byprovisions, reservesand current yearprofits. In Basel I agreement, Tier 1 capital is a minimum of 4% ownership equitybut investors generally require a ratio of 10%.

Contents

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1 Tier 1 capital ratio 2 See also 3 References

4 External links

[edit] Tier 1 capital ratio

The Tier 1 capital ratio is the ratio of a bank's coreequity capital to its total risk-weighted assets(RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit riskaccording to a formula determined by the Regulator (usually the country'scentral bank). Mostcentral banks follow theBank for International Settlements (BIS) guidelines in setting formulae forasset risk weights. Assets like cash and coins usually have zero risk weight, while certain loansmay have a risk of 100%.
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As an example, assume a bank with $2 of equity receives a client deposit of $10 and lends out all$10. Assuming that the loan, now a $10 asset on the bank's balance sheet, carries a risk weightingof 90%, the bank now holds risk-weighted assets of $9 ($10*90%). Using the original equity of $2,the bank's Tier 1 ratio is calculated to be $2/$9 or 22%.

It is important to note that the Tier 1 capital ratio may be calculated as the Tier 1 common capitalratio or the Tier 1 total capital ratio. Preferred shares and non-controlling interests are included inthe Tier 1 total capital ratio but not the Tier 1 common ratio. As a result, the common ratio willalways be less than or equal to the total capital ratio. In the example above, the two ratios are thesame.

Tier 2 capital


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Tier 2 capital is a measure of a bank's financial strength with regard to the second most reliableform offinancial capital from a regulatorypoint of view. The forms of banking capital werelargely standardized in the Basel I accord, issued by the Basel Committee on Banking Supervisionand left untouched by theBasel II accord. National regulators of most countries around the worldhave implemented these standards in local legislation.

Tier 1 capital is considered the more reliable form of capital, which comprises the most junior

(subordinated) securities issued by the firm. These include equity and qualifying perpetualpreferred stock.

There are several classifications of tier 2 capital. In the Basel I Accord, tier 2 capital is composedofsupplementary capital, which is categorised as undisclosed reserves, revaluation reserves,general provisions, hybrid instruments and subordinated term debt. Supplementary capital can beconsidered tier 2 capital up to an amount equal to that of the core capital.[1]

Contents

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1 Undisclosed Reserves 2 Revaluation Reserves 3 General Provisions 4 Hybrid Instruments 5 Subordinated Term Debt 6 See also
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7 References

8 External links

[edit] Undisclosed Reserves

Undisclosed reserves are not common, but are accepted by some regulators where a bank has madea profit but this has not appeared in normal retained profits or in general reserves of the bank.

[edit] Revaluation Reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase invalue is brought to account. A simple example may be where a bank owns the land and building ofits head-offices and bought them for $100 a century ago. A current revaluation is very likely toshow a large increase in value. The increase would be added to a revaluation reserve.

[edit] General Provisions

A general provision is created when a company is aware that a loss may have occurred but is notsure of the exact nature of that loss. Under pre-IFRSaccounting standards, general provisions werecommonly created to provide for losses that were expected in the future. As these did not representincurred losses, regulators tended to allow them to be counted as capital.

[edit] Hybrid Instruments

Hybrids are instruments that have some characteristics of both debt andshareholders' equity.Provided these are close to equity in nature, in that they are able to take losses on the face valuewithout triggering aliquidationof the bank, they may be counted as capital.Preferred stocks arehybrid instruments.

[edit] Subordinated Term Debt

Subordinated debt is debt that ranks lower than ordinary depositors of the bank.

Capital requirement


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The capital requirement is abank regulation, which sets a framework on howbanks anddepository institutions must handle theircapital. The categorization of assets and capital is highlystandardized so that it can be risk weighted (see Risk-weighted asset). Internationally, theBaselCommittee on Banking Supervision housed at the Bank for International Settlementsinfluenceeach country's banking capital requirements. In 1988, the Committee decided to introduce a capital

measurement system commonly referred to as the Basel Accord. This framework has beenreplaced by a significantly more complex capital adequacy framework commonly known as BaselII. After 2012 it will be replaced by Basel III.

While Basel II significantly alters the calculation of the risk weights, it leaves alone the calculationof the capital. Thecapital ratio is the percentage of a bank's capital to its risk-weighted assets.Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevantAccord.

Each national regulator normally has a very slightly different way of calculating bank capital,designed to meet the common requirements within their individual national legal framework.

Most developed countries implement Basel I and II, stipulate lending limits as a multiple of abanks capital eroded by the yearly inflation rate.

The 5 Cs of Credit - Character, Cash Flow, Collateral, Conditions and Capital, have been replacedby one single criterion. While the international standards of bank capital were laid down in the1988Basel I accord,Basel II makes significant alterations to the interpretation, if not thecalculation, of the capital requirement.

Examples of national regulators implementing Basel II include the FSA in the UK,BaFin inGermany, OSFIin Canada,Banca d'Italia in Italy.

In the United States, depository institutions are subject to risk-based capital guidelines issued bythe Board of Governors of the Federal Reserve System (FRB). These guidelines are used toevaluate capital adequacy based primarily on the perceived credit riskassociated withbalancesheet assets, as well as certain off-balance sheet exposures such as unfunded loan commitments,letters of credit, and derivatives andforeign exchange contracts. The risk-based capital guidelinesare supplemented by aleverage ratio requirement. To be adequately capitalized under federal bankregulatory agency definitions, abank holding company must have a Tier 1 capital ratio of at least
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4%, a combined Tier 1 andTier 2 capital ratio of at least 8%, and a leverage ratio of at least 4%,and not be subject to a directive, order, or written agreement to meet and maintain specific capitallevels. To be well-capitalizedunder federal bank regulatory agency definitions, abank holdingcompany must have a Tier 1 capital ratio of at least 6%, a combined Tier 1 and Tier 2 capital ratioof at least 10%, and a leverage ratio of at least 5%, and not be subject to a directive, order, or

written agreement to meet and maintain specific capital levels. These capital ratios are reportedquarterly on theCall Report orThrift Financial Report. Although Tier 1 capital has traditionallybeen emphasized, in the Late-2000s recession regulators and investors began to focus on tangiblecommon equity, which is different from Tier 1 capital in that it excludespreferred equity.[1]

Contents

[hide]

1 Regulatory capitalo 1.1 Tier 1 capitalo 1.2 Tier 2 (supplementary) capital

1.2.1 Undisclosed Reserves 1.2.2 Revaluation reserves 1.2.3 General provisions 1.2.4 Subordinated-term debt

2 Different International Implementations 3 Common capital ratios

o 3.1 Example

4 See also 5 References

6 External links

[edit] Regulatory capital

In the Basel I accord bank capital was divided into two "tiers", each with some subdivisions.

[edit] Tier 1 capital

Tier 1 capital, the more important of the two, consists largely of shareholders' equity. This is theamount paid up to originally purchase the stock (or shares) of the Bank (not the amount thoseshares are currently trading for on the stock exchange), retained profits subtracting accumulated

losses, and other qualifiable Tier 1 capital securities (see below). In simple terms, if the originalstockholders contributed $100 to buy their stock and the Bank has made $10 in retained earningseach year since, paid out no dividends, had no other forms of capital and made no losses, after 10years the Bank's tier one capital would be $200. Shareholders equity and retained earnings are nowcommonly referred to as "Core" Tier 1 capital, whereas Tier 1 is core Tier 1 together with otherqualifying Tier 1 capital securities.
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Regulators have since allowed several other instruments, other than common stock, to count in tierone capital. These instruments are unique to each national regulator, but are always close in natureto common stock. One of these instruments is referred to Tier 1 capital securities.

Apart from a few minor issues, these began to gain momentum from 1998 and usually consisted of

a perpetual security (ie no final maturity) with a fixed coupon for 10 years. After 10 years the issuewould be callable at par (ie 100% of original notional amount). If not called, the coupon wouldstep up usually to 100bp (1bp=0.01%) above the initial launch spread (eg if launched atLIBOR+60, issue would step toLIBOR+160bp). As with equity, their coupons (dividends) werenot guaranteed and usually could only be paid provided the bank had sufficient distributablereserves. If the coupon was not paid, the coupon would never be paid (ie was non-cumulative).They were also loss absorbing to provide a further buffer for depositors. Until the credit crunch of2007-2009, 99% of all issues were called as they could be refinanced at cheaper levels to theirpost-step coupon. However, even though many issues were trading wider than their step levelduring the credit crunch most were still called much to the annoyance of the regulators. Holders ofthe securities (egpension funds, asset managers) argued that they needed these issues to be called

and coupons paid as, unlike shareholders, they do not benefit in the upside of a bank's equity price(ie they buy the bonds at 100% and hopefully receive 100% 10years later even though equity couldhave rallied by 300%). They also hold no voting rights (again, unlike shareholders). The onlybenefit of holding the securities is the coupon and getting paid back your initial outlay after 10years. If they weren't called, or coupons paid, the holders argued that this would thereforeconsiderably affect the cost of issuing other Lower Tier 2 or senior issues. Due to the fact thatsenior issuance vastly outweighed Tier 1 capital issuance, the banks therefore mostly decided tocall these issues at the first call/step date and continued to pay coupons, even though it was un-economic to do so. In certain countries, eg Germany, the regulator took a strong line and forbadethese issues to be called. Similarly for the state-owned banks that had restrictions imposed on themby the EU. This therefore has led to calls that such issues need to be stronger in language in the

original prospectus and that coupons can ONLY be called or coupons paid provided there issufficient distributable reserves. This will be part of future bank capital requirements which are inthe process of being decided as part of Basel 3.

[edit] Tier 2 (supplementary) capital

There are several classifications oftier 2 capital, which is composed of supplementary capital andare called temporary capital unlike tier 1 which is permanent capital. In the Basel I accord, theseare categorized as undisclosed reserves, revaluation reserves, general provisions, hybridinstruments and subordinated term debt.

[edit] Undisclosed Reserves

Undisclosed reserves are not common, but are accepted by some regulators where a Bank hasmade a profit but this has not appeared in normal retained profits or in general reserves. Most ofthe regulators do not allow this type of reserve because it does not reflect a true and fair picture ofthe results.
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[edit] Revaluation reserves

A revaluation reserve is a reserve created when a company has an asset revalued and an increase invalue is brought to account. A simple example may be where a bank owns the land and building ofits headquarters and bought them for $100 a century ago. A current revaluation is very likely to

show a large increase in value. The increase would be added to a revaluation reserve.

[edit] General provisions

A general provision is created when a company is aware that a loss may have occurred but is notsure of the exact nature of that loss. Under pre-IFRSaccounting standards, general provisions werecommonly created to provide for losses that were expected in the future. As these did not representincurred losses, regulators tended to allow them to be counted as capital.

[edit] Subordinated-term debt

Subordinated debt is classed as Lower Tier 2 debt, usually has a maturity of a minimum of 10yearsand ranks senior to Tier 1 debt, but subordinate to senior debt. To ensure that the amount of capitaloutstanding doesn't fall sharply once a Lower Tier 2 issue matures and, for example, not bereplaced, the regulator demands that the amount that is qualifiable as Tier 2 capital amortises (iereduces) on a straight line basis from maturity minus 5 years (eg a 1bn issue would only count asworth 800m in capital 4years before maturity). The remainder qualifies as senior issuance. For thisreason many Lower Tier 2 instruments were issued as 10yr non-call 5 year issues (ie final maturityafter 10yrs but callable after 5yrs). If not called, issue has a large step - similar to Tier 1 - therebymaking the call more likely.

[edit] Different International Implementations

Regulators in each country have some discretion on how they implement capital requirements intheir jurisdiction.

For example, it has been reported[2] that Australia'sCommonwealth Bankis measured as having7.6% Tier 1 capital under the rules of the Australian Prudential Regulation Authority, but thiswould be measured as 10.1% if the bank was under the jurisdiction of the UK's Financial ServicesAuthority. This demonstrates that international differences in implementation of the rule can varyconsiderably in their level of strictness.

[edit] Common capital ratios Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6% Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 and Tier 2) / Risk-

adjusted assets >=10% Leverage ratio = Tier 1 capital / Average total consolidated assets >=5% Common stockholders equity ratio = Common stockholders equity / Balance

sheet assets
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[edit] Example

Listed below are the capital ratios in Citigroup at the end of 2003 [1].

Ratios

At year-end 2003

Tier 1 capital 8.91%

Total capital (Tier 1 and

Tier 2)

12.00

%

Leverage (1) 5.56%

Common stockholders

equity 7.67%

(1) Tier 1 capital divided byadjusted average assets.

Components of Capital Under Regulatory Guidelines

In millions of dollars at year-end 2003

Tier 1 capital

Common stockholders equity$

96,889

Qualifying perpetual preferred stock 1,125

Qualifying mandatorily redeemable securities of

subsidiary trusts6,257

Minority interest 1,158

Less: Net unrealized gains on securities available-for-

sale (1)(2,908)

Accumulated net gains on cash flow hedges, net of tax

(751) (1,242)(751)

Intangible assets: (2)

Goodwill (27,581)
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Other disallowed intangible assets (6,725)

50% investment in certain subsidiaries (3) (45)

Other (548)

Total Tier 1 capital 66,871

Tier 2 capital

Allowance for credit losses (4) 9,545

Qualifying debt (5) 13,573

Unrealized marketable equity securities gains (1) 399

Less: 50% investment in certain subsidiaries (3) (45)

Total Tier 2 capital 23,472

Total capital (Tier 1 and Tier 2)$

90,343

Risk-adjusted assets (6)$750,2

93

(1) Tier 1 capital excludes unrealized gains and losses on debt securities available-for-

sale in accordance with regulatory risk-based capital guidelines. The federal bank

regulatory agencies permit institutions to include in Tier 2 capital up to 45% of pretax

net unrealized holding gains on available-for-sale equity securities with readily

determinable fair values. Institutions are required to deduct from Tier 1 capital net

unrealized holding losses on available-for-sale equity securities with readily

determinable fair values, net of tax.

(2) The increase in intangible assets is primarily due to the acquisition of the Sears

credit card portfolio in November 2003.

(3) Represents unconsolidated banking and finance subsidiaries.

(4) Includable up to 1.25% of risk-adjusted assets. Any excess allowance is deducted

from risk-adjusted assets....

(5) Includes qualifying subordinated debt in an amount not exceeding 50% of Tier 1

capital.
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(6) Includes risk-weighted credit equivalent amounts, net of applicable bilateral netting

agreements, of $39.1 billion for interest rate, commodity and equity derivative

contracts and foreign exchange contracts, as of December 31, 2003, compared to

$31.5 billion as of December 31, 2002. Market risk-equivalent assets included in risk-

adjusted assets amounted to $40.6 billion and $30.6 billion at December 31, 2003 and

2002, respectively. Risk-adjusted assets also includes the effect of other off-balance

sheet exposures such as unused loan commitments and letters of credit and

reflects deductions for certain intangible assets and any excess allowance for credit

losses.
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tier 1 capital

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