TIER 1 CAPITAL (ENCYCLOPEDIA)

The Basel Committee classifies bank capital identifying 3 different levels: Tier 1 capital, Tier 2 capital, and Tier 3 capital. They are characterised by increasing degree of liquidity and decreasing degree of redemption priority and ensure the coverage of financial losses, i.e., the bank survival. Tier 1 capital identifies the main components of equity capital: shares, unavailable balance sheet reserves, and shareholders’ retained earnings, accrued over the life of the bank. It represents the amount of capital that allows a bank to absorb losses without affecting interests of depositors. The Tier 1, compared to Tier 2 and to Tier 3, is the highest-quality component capital because it guarantees the depositors from any negative circumstances in which the bank could incur (occasional or persistent losses over time; "bankruptcy" with a subsequent liquidation of the bank capital).

The Tier 1 Capital goes beyond the notion of accounting equity.  Rather, it tends to approach  the notion of net present value, at a given  instant in time, of all the cash flows that the bank will be able to generate over the years. Thus, it is a measure of cash flows and not of net accounting profit, since it is used to monitor the solvency rather than profitability, of bank capital. In this sense, Tier 1 Capital identifies what would be the fair value of the bank (i.e., equilibrium price) once deducted the net present value of its third parties debt from the amount of RISK-WEIGHTED ASSETS (RWA). To this purpose, in fact, the calculation of Tier 1 Capital does not consider certain items that frequently increase the book value of the bank. These are, for example,  the amount of intangible assets, the current year losses, or the company own shares held in the portfolio. Tier 1 Capital can also include hybrid capital instruments, represented by all those irredeemable liabilities, similar to the equity component, for which the issuer may suspend reimbursement to the holders subject to the approval of the central bank. This may occur when there exist special negative circumstances  which could seriously compromise the bank solvency. For example, they might apply: When the balance sheet losses result in a reduction of the capital and reserves that do fall below the minimum level of capital required to run the bank activity. In this case, amounts arising from such liabilities as well as related interests may be used to cover losses and guarantee the bank survival. When economic results show a very negative trend, the creditors’ reimbursement right may be suspended to the extent needed to prevent or minimize the rise of losses. When the bank is placed in liquidation, debts can be repaid only after other creditors, not equally subordinated, have been satisfied. Generally, the hybrid capital instruments included into the Tier 1 Capital, must have a duration equal to, or higher than, 10 years. The Tier 1 Capital is regulated in order to assess the solvency of the Bank, through the calculation of the Core Tier 1 ratio. The calculation is relatively simple: it is necessary to relate the Core Tier 1 (with a maximum amount of hybrid capital lower than 15%) to risk-weighted assets (RWA) according to the criteria of Basel III). In other terms, this ratio evaluates the degree of bank capitalization relative to its assets, and in the light of the risk generated by the bank activity. An optimal level of Tier 1 capital ratio should be equal to 8%, while according to Basel II it should be at least 6%. Banks that do not meet this level are often called to recapitalize with the aim of re-establishing a balance between financial sources and uses and ensure the stability of the bank over time.

Editor: Melania MICHETTI