Define Common Equity Tier 1 (CET1)

Common Equity Tier 1 (CET1)

What Is CET1 (Common Equity Tier 1)?

CET1 (Common Equity Tier 1) is a Tier 1 capital component made up mostly of common stock owned by a bank or other financial institution. It's a capital measure that was implemented in 2014 as a preventative step to preserve the economy from a financial disaster. By 2019, it is envisaged that all banks will have achieved the statutory CET1 level of 4.5 percent. 1

TAKEAWAYS IMPORTANT

• equity in a group Tier 1 includes the most evident equities held by a bank, such as cash, shares, and so on.

• The capital-to-assets ratio (CET1) compares a bank's capital to its assets.

• Additional Tier 1 capital is made up of non-common equity instruments.

• In the case of a crisis, Tier 1 equity is depleted first.

• Many bank stress tests employ Tier 1 capital as a starting point for determining a bank's liquidity and ability to withstand a difficult monetary event.

Tier 1: Understanding Common Equity (CET1)

The Basel Committee updated a set of worldwide criteria to examine and monitor banks' capital adequacy following the 2008 financial crisis. These rules, commonly known as Basel III, evaluate a bank's assets to its capital to see if it can withstand a crisis. 2

Banks require capital to sustain unanticipated losses that occur during the usual course of business. Basel III tightens capital requirements by restricting the types of capital that a bank can incorporate in its various capital tiers and structures. 3 Tier 2 capital, Tier 1 capital, and common equity Tier 1 capital make up a bank's capital structure.

Tier 1 Capital Calculation

CET1 capital + xtra Tier 1 capital equals Tier 1 capital (AT1). Common equity Tier 1 is a bank's fundamental capital, and it consists of common shares, stock surpluses from common share issuances, retained profits, common shares issued by subsidiaries and owned by third parties, and accrued other comprehensive income (AOCI).

Instruments that are not common stock but are eligible for inclusion in this tier are referred to as additional Tier 1 capital. A contingent convertible or hybrid instrument, which has a perpetual duration and can be converted into equity when a trigger event happens, is an example of AT1 capital. When CET1 capital falls below a specific threshold, an event happens that triggers a security to be converted to equity.

IMPORTANT : CET1 is a capital strength metric that measures a bank's solvency.

The CET1 ratio, which compares a bank's capital to its assets, is a better representation of this metric. Because not all assets carry the same level of risk, a bank's assets are weighted depending on the credit risk and market risk they pose.

A government bond, for example, might be classified as a "no-risk asset" with a risk weighting of zero percent. A subprime mortgage, on the other hand, may be regarded as a high-risk asset with a 65 percent weighting. All banks must have a minimum CET1 to risk-weighted assets (RWA) ratio of 4.5 percent, according to Basel III capital and liquidity standards. 4

equity in a group Tier 1 capital to risk-weighted assets ratio = common equity tier 1 capital to risk-weighted assets

Lower Tier 2, Upper Tier 1, AT1, and CET1 make up a bank's capital structure. Because CET1 is at the bottom of the capital structure, any losses are taken first from this tier in the case of a crisis. If the deduction causes the CET1 ratio to fall below the legal minimum, the bank will be overrun or shut down by regulators until it rebuilds its capital ratio to the required level.

Regulators may bar the bank from paying dividends or staff bonuses during the reconstruction period. In the event of bankruptcy, stock investors suffer the brunt of the losses, followed by hybrid and convertible bonds, and finally Tier 2 capital.

The European Banking Authority used the CET1 ratio in 2016 to perform stress tests to determine how much capital banks would have left in the event of a financial catastrophe. The tests were conducted during a difficult time in the Eurozone, when many banks were dealing with large volumes of nonperforming loans (NPLs) and falling stock values. Most banks would be able to weather a crisis in 2016, according to the results of the test. 5