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Under Basel III, define Tier 1 and Tier 2 capital with their components, and calculate where suitable the required Tier 1 equity capital, the total Tier 1 capital and the total capital.

FRM® Part II · Operational Risk and Resilience · Solvency, Liquidity, and Other Regulation After the Global Financial Crisis · FRM2.ORR.22.d

The idea

Basel III splits regulatory capital into Tier 1 and Tier 2. Tier 1 is Common Equity Tier 1 (CET1), meaning common shares plus retained earnings and reserves less deductions such as goodwill and deferred tax assets, plus Additional Tier 1 (AT1). AT1 is chiefly perpetual non-cumulative preferred shares that can absorb losses while the bank is a going concern. Tier 2 is gone-concern capital, mainly subordinated debt with an original maturity of at least five years. The baseline minimums, as percentages of risk-weighted assets (RWA), are CET1 4.5 percent, total Tier 1 6 percent and total capital 8 percent. So AT1 must supply at least 1.5 percent and Tier 2 can fill the last 2 percent. These come before any buffers, and the requirement a bank actually faces varies by jurisdiction. Capital required at each level is its ratio applied to risk-weighted assets: Required = ratio × RWA. The usual slip is letting AT1 or Tier 2 cover a CET1 shortfall. Each level must be met separately.

Formulas

Basel III total capital ratio

Total ratio = (CET1 + AT1 + T2) ÷ RWA

CET1
common equity tier 1 after deductions
AT1
additional tier 1 capital
T2
tier 2 capital
RWA
risk-weighted assets

Each level is tested separately: CET1 at 4.5, Tier 1 at 6 and total at 8 percent of RWA. Surplus AT1 or T2 cannot cover a CET1 gap.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following are the components of Common Equity Tier 1 capital under Basel III?

  1. Perpetual non-cumulative preferred shares and common sharesWhy not: Preferred shares are Additional Tier 1, not CET1.
  2. Common shares and subordinated debt with an original maturity of 10 yearsWhy not: Subordinated debt belongs to Tier 2 capital, not CET1.
  3. Retained earnings plus loan loss reserves for expected losses on performing loansWhy not: Loan loss provisions are not CET1; the quality of CET1 rests on common equity and earnings only.
  4. Common shares and retained earnings, less regulatory deductions such as goodwill - correct

CET1 is common shares, retained earnings and reserves, net of deductions such as goodwill and deferred tax assets. AT1 and Tier 2 hold hybrid and debt-like instruments.

A harder one

A bank has risk-weighted assets of USD 600 billion and holds exactly the minimum Tier 1 capital under Basel III before buffers. What is the least Tier 2 capital it needs to meet the minimum total capital requirement?

  1. USD 48 billionWhy not: Uses the full 8% total capital figure, forgetting that Tier 1 already supplies 6%.
  2. USD 12 billion - correct
  3. USD 27 billionWhy not: Uses the CET1 minimum of 4.5% rather than the gap between total capital and Tier 1.
  4. USD 21 billionWhy not: Subtracts only the CET1 minimum (4.5%) from 8%, forgetting that total Tier 1 is 6% with AT1 included.

Total capital 8% - Tier 1 6% = 2% of RWA. 2% x 600 = 12.

The hardest tier

A bank reports common shares of USD 30 billion, retained earnings of USD 22 billion, goodwill of USD 6 billion, perpetual non-cumulative preferred shares of USD 10 billion and eligible subordinated debt of USD 14 billion. Risk-weighted assets are USD 500 billion. Its total capital ratio under Basel III is closest to:

  1. 15.2%Why not: Fails to deduct goodwill from CET1 before adding AT1 and Tier 2.
  2. 11.2%Why not: Computes the Tier 1 ratio, leaving out the Tier 2 subordinated debt.
  3. 12.0%Why not: Omits the preferred shares (AT1), which count in Tier 1 and so in total capital.
  4. 14.0% - correct

CET1 = 30+22-6 = 46. Tier 1 = 46+10 = 56. Total = 56+14 = 70. Total ratio = 70/500 = 14.0%.

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