Metric of the Month - Tier 1 Risk Based Capital

March 4, 2015 | Stephen Timme

What time is it?? It’s metric time!!

This month's topic is Tier 1 Risk Based Capital Ratio for banking institutions. Tier 1 Risk Based Capital Ratio is one of the few capital ratios commonly used to measure the capital adequacy of a bank. Following the global economic recession of 2008, financial regulators around the world have been working on tighter guidelines to safeguard the sustainability of global banks and prevent the repeat of such events in the future. As a result, in December 2010, the Basel Committee on Banking Supervision (BCBS) released Basel III, which sets higher levels for capital requirements for banking institutions. Consequently, banks around the globe have diligently worked to meet these stringent guidelines. If you have clients in the banking industry, you undoubtedly hear this term frequently – but how is it really measured and why is it meaningful? Read on….

Who uses it?

Banking institutions around the globe uses the Tier 1 Risk Based Capital Ratio to measure their financial strength. Regulators also use this ratio to grade a firm’s capital adequacy. Each national regulator normally has a very slightly different method of calculating bank capital, designed to meet the common requirements within their individual national legal framework. For instance, in the US the Federal Reserve establishes capital requirements for banking companies in the US and evaluates their compliance with such capital requirements. The Office of the Comptroller of the Currency (the “OCC”) also establishes similar capital requirements and standards for the Company’s Subsidiary Banks. Examples of national regulators implementing these capital requirements outside of the US include the Federal Financial Supervisory Authority in Germany and the Office of the Superintendent of Financial Institutions in Canada.

How is it measured?

Tier 1 Risk Based Capital Ratio is calculated as follows: Tier 1 capital / Risk Weighted Assets.

What’s in it?

There are two components in the Tier 1 Risk Based Capital Ratio. First, there is the Tier 1 capital which consists predominantly of common shareholders’ equity, as well as qualifying preferred stock and qualifying restricted core capital elements. A bank’s Tier 1 capital is not shown on the balance sheet, but it is typically disclosed in the footnotes to the financial statements. The second component is the risk weighted assets (RWA) which represents the total of the carrying value of each asset class multiplied by their assigned risk weighting, as defined by banking regulations.

Why is it important?

Risk-based capital requirements, like the Tier 1 Risk Based Capital Ratio, exist to protect the firms, their investors and customers, and the economy as a whole. These requirements are put into place to ensure that financial institutions do not take on excess leverage and become insolvent. In addition, Regulators use the Tier 1 capital ratio to grade a firm's capital adequacy as one of the following rankings: Well-Capitalized, Adequately Capitalized, Under-capitalized, Significantly Under-capitalized, and Critically Under-capitalized. Failure to meet these capital guidelines will result in restrictions on a company’s ability to make capital distributions, including the payment of dividends and the repurchase of stock, and to pay discretionary bonuses to executive officers.

What drives it?

One of the primary drivers of Tier 1 Risk Based Capital Ratio is risk weighted assets (RWA). The tier 1 risk based capital ratio of a company can be improved by reducing the company’s RWA. Companies can reduce their RWA by improving their credit profile and model refinements for their commercial portfolios. In addition, the Tier 1 Risk Based Capital Ratio can be influenced by the company’s earnings performance, the company’s level of capital, as well as the volatility of that capital.

What's the goal?

In the US the Collins Amendment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (commonly referred to as "Dodd-Frank") imposes minimum risk-based capital requirements for insured depository institutions, depository institution holding firms and nonbank financial companies that are supervised by the Federal Reserve. Under the rules, banking institutions are subject to minimum Tier 1 capital ratio of 4%. To be considered “well-capitalized,” a ratio of 6% is required.

Posted in KPI, Metric Matrix, Metric of the Month, Key Performance Indicator