Core capital or Tier 1 capital is the reserves that a bank has to back its business activities. It composed of disclosed reserves and common stock/ordinary shares. It can also include non-cumulative, non-redeemable preferred stock.
As well as core capital, banks also use instruments to accumulate Tier 1 capital, such as preference shares and CoCos. However, such instruments must adhere to strict conditions. Capital acquired through these instruments can only account for 15% of the bank’s total Tier 1 capital. See also Additional Tier 1 or AT1
The tier one capital ratio is the ratio of a bank’s tier one capital to its risk weighted assets (all the bank’s assets – the loans that it has made – weighted according to a risk formula that is usually set by the local regulator).
Common Equity Tier 1 capital (CET1) is the highest quality of regulatory capital, as it absorbs losses immediately when they occur.
Additional Tier 1 capital (AT1) also provides loss absorption on a going-concern basis, although AT1 instruments do not meet all the criteria for CET1. For example, some debt instruments, such as perpetual contingent convertible capital instruments, may be included in AT1 but not in CET1.
In contrast, Tier 2 capital is gone-concern capital. That is, when a bank fails, Tier 2 instruments must absorb losses before depositors and general creditors do. The criteria for Tier 2 inclusion are less strict than for AT1, allowing instruments with a maturity date to be eligible for Tier 2, while only perpetual instruments are eligible for AT1.
Total available regulatory capital is the sum of these two elements – Tier 1 capital, comprising CET1 and AT1, and Tier 2 capital. Each of the categories has a specific set of criteria that capital instruments are required to meet before their inclusion in the respective category. Banks are required to maintain specified minimum levels of CET1, Tier 1 and total capital, with each level set as a percentage of risk-weighted assets.
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