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Tier 1 Capital – The Easy Way to See the Strength of a Bank’s Balance Sheet

Banks take the lead in earnings season every session, and much is made of the bank’s ability to withstand losses if the economy is in a bad spot. With the current uncertainty in the world as a result of Covid-19, banks are preparing for the worst. A topic that comes up around that time is the Tier 1 Capital Ratio as a means of assessing a bank’s financial strength.

What do we truly know about the strength of a bank’s balance sheet? We can assess the strength via metrics such as debt to equity, debt to assets, and so on. But using the Tier 1 capital ratio is a quick way to judge the level of concern you might have about a bank’s ability to withstand any issues.

After the financial meltdown in 2007, the FDIC decided they needed to find a way to increase a bank’s capital requirements that would provide a measure of safety in the event of an event similar to 2007.

One of the outgrowths of that decision is the Tier 1 capital ratio, and there have been amendments along the way, but as of today, it is an easy way to determine the strength of said bank’s balance sheet.

Some of the information we are going to discuss today is “inside baseball” type of information and is not for beginners, per se. If you are new to investing in banks, then I suggest you check the below post first.

Bank Stocks Analysis: Understanding Basic Metrics and the Banking Industry

In today’s post, we will learn:

  • What is Tier 1 Capital?
  • Tier 1 Capital Components
  • Relationship Between Tier 1 Capital and Stress Tests
  • Tier 1 Capital Ratio Formula
  • Tier 1 Capital Ratio Stats for the Banking Industry

Ok, let’s dive in and discover more about the Tier 1 capital ratio.

What is Tier 1 Capital?

Tier 1 capital as described by Investopedia:

“Tier 1 capital is used to describe the capital adequacy of a bank and refers to core capital that includes equity capital and disclosed reserves. Equity capital is inclusive of instruments that cannot be redeemed at the option of the holder.”

In English, that means that Tier 1 Capital is the best example of the bank’s capital. What is the bank’s capital? Bank capital is the money it has stored to keep the bank going through risky transactions it performs, such as investing, lending, or trading.

In 2013, bank regulators approved the Basel III, or Basel Accord in order to better respond to deficiencies that existed in financial regulations that were exposed for all to see in 2007 and 2008.

The Basel Accord determined that required each bank to hold a certain level of Tier 1 capital at all times. The level is measured by the Tier 1 capital ratio, which we will discuss in a moment.

As we mentioned above, Tier 1 concerns itself with the core capital of the bank, mainly this refers to the bank’s disclosed reserves and common stock, and non-redeemable non-cumulative preferred stock available for calculations of the Tier 1 capital ratio.

Tier 1 is different from Tier 2, also created with the Basel Accord. Tier 2 capital includes supplementary capital, such as loan-loss, revaluation reserves, and undisclosed reserves. Tier 2 capital is considered less reliable, and if considering those numbers is best used separately when evaluating the riskiness of the bank.

Regulators use the Tier 1 capital as a tool to get banks to increase capital buffers before the bank would become insolvent.

The crisis of 2007 highlighted the fact that too many banks had too little capital to remain liquid or absorb losses. The bottom line, too many banks were funded with too much debt and not enough equity, which led to instability.

So what happens if a bank falls below the minimum levels required by Tier 1 capital?

If the bank falls below that level, it is required to build its capital back to the required level, or the bank will be overtaken by regulators or shut down.

In the event of a capital rebuild, the bank is prohibited from distributing dividends, share repurchases, or paying employee bonuses. If the bank is insolvent, then the procession of investors to receive any return of investments is the same as any shareholders, bonds, preferred shares, and common shares.

Ok, now that we understand what Tier 1 capital is and how it works, let’s find out what constitutes the core capital of a bank.

Tier 1 Capital Components

Tier 1 capital is made up of shareholders’ equity and retained earnings. Part 324 of the Basel Accord determines that Tier 1 capital consists of common equity tier 1 capital and additional Tier 1 capital.

What is the common equity Tier 1 capital?

Common equity Tier 1 capital is the most loss-absorbing form of capital; it includes common stock, a surplus of treasury stock, retained earnings, and certain accumulated other comprehensive income (AOCI).

I apologize, but there will be acronyms, no way around it as we are dealing with government agencies creating these rules.

There are many rules and regulations around the AOCI as it relates to bond portfolio appreciation and depreciation that could have significant impacts of the Tier 1 capital, if you would like to learn more, please follow this link to the FDIC regulations on Tier 1 capital.

As pertains to our discussion, there are requirements of certain deductions from the common equity Tier 1, such as goodwill, deferred tax assets, other intangible assets, gains on sales of securities, and other investments in another bank’s capital.

Banks also must make deductions based on additional specific assets such as:

  • Mortgage servicing assets
  • Deferred tax assets tied to certain timing differences
  • Significant investments in other bank’s common stock

Ok, so how does all that gobbly goop relate to the capital structure of the bank, and how is it measured?

The Basel III Accord we mentioned earlier established minimums that each bank must be above, for example, the minimum capital required to maintain is 10.5 percent, of which 9 percent must be common equity Tier 1. It also maintains that the Tier One capital ratio must contain at least 6 percent of CET1 (common equity Tier 1).

According to the Basel Accord, a bank’s risk-weighted assets will include all assets that the bank holds that are systemically weighted for credit risk.

Central banks are tasked with determining the weighting scale for different asset classes, for example:

  • Cash and government securities carry zero risks unless you are in Argentina!
  • Mortgage or car loans carry more risk.

The risk-weighted assets would be assigned an increased weighting based on the assets credit risk; the weighting would be on a gradual scale.

For example, cash carries 0 percent weight, loans on a rising level of riskiness would carry weights of 20%, 50%, or 100%.

Tier 1 capital differs from common equity Tier 1 slightly, Tier 1 capital includes the bank’s equity, disclosed reserves, and preferred stock. CET1 excludes any preferred stock or minority interests and is made up of common stock, retained earnings, and AOCI.

Before discussing the measurement of Tier 1 capital, let’s take a small detour.

Relationship Between Tier 1 Capital, Stress Tests

Bank stress tests were put in place after the financial crisis of 2007 to 2009. The ensuing Great Recession left many banks in tatters. The crisis revealed the level of undercapitalization and revealed the vulnerability to any distress to the economy.

The result of these observations was to institute more regulations regarding higher capital requirements, more equity, less debt. The regulations required more reporting on the capital levels and for banks to regularly determine their solvency and report on those findings.

A bank’s stress test is an analysis to determine the capital levels required of banks to survive various economic downturns. The determinations are based on computer simulations and have varying degrees of intensity.

Any bank that has a minimum of $50 billion in assets is required to proceed with a stress test quarterly. The stress tests cover many areas of banks, such as credit risk, market risk, and liquidity risk.

Examples of scenarios that are enacted in the stress tests include a Caribbean hurricane, historical events such as the Great Depression.

Banks use nine quarters of projected financials to determine if they have enough capital to survive the scenarios.

Tier 1 capital is the main ingredient of these stress tests; the regulators are attempting to determine whether the bank has enough capital in the form of equity to survive an economic disaster.

When a bank fails a stress test, it is big news. Recently Santander and Deutsche Bank have stumbled in the case of Deutsche several times. It is unusual but not unheard of, but no one wants to hear their bank is in trouble.

Wells Fargo, with all of its trials and tribulations of recent years, spends considerable effort to maintain its Tier 1 capital to a satisfactory level and ensure that investors see the bank as strong and stable.

The regulators put Wells Fargo through the paces every year and have put additional restrictions on the bank, such as limiting or capping the asset level the bank is allowed to maintain.

Again a major component of the measurement of a bank’s capital strength is the Tier 1 capital and CET1.

Ok, let’s move onto the Tier 1 capital ratio.

Tier 1 Capital Ratio Formula

The formula for calculating the Tier 1 capital ratio is simple; it is as follows:

Tier 1 Capital Ratio = ( Core Capital / Risk Weighted Assets ) x 100

Let’s use an easy example to illustrate how this works, before looking at some real-life example.

Let’s assume our bank, Sather Capital, holds $2 million in core capital and lent out $20 million to Ahern Limited. The loan comes with a risk-weighting of 80%. Now, let’s calculate the Tier 1 capital ratio.

Tier 1 Capital Ratio = ( $2,000,000 / ($20,000,000 x 80%)) x 100
Tier 1 Capital Ratio = 12.5 percent

Ok, that’s pretty simple, why don’t we try an example from a real-life bank?

The first example I would like to analyze is Wells Fargo (WFC). To find the information we need to calculate the ratio we look in the annual or quarterly report for the Common Equity Tier 1 or Tier 1 Capital using the Control F search function as the information we need to calculate the ratio is not listed on the balance sheet as a specific line item.

Wells Fargo does a great job of laying out the ratios, as well as the components making up the calculations.

Click to zoom

So if we first calculate the CET1 or common equity Tier 1, we get:

CET1 ratio = ($133,055 / $1,195,423) x 100= 11.13 percent

If you take a look at the Tier 1 capital ratio, we get:

Tier 1 Capital Ratio = ($152,871 / $1,195,423) x 100 = 12.79 percent

Pretty easy, huh?

And notice that Wells Fargo was well above both minimum requirements, with the CET1 at 11.13 percent, and Tier 1 capital ratio at 12.79 percent. Well above the minimum requirements of 9 percent and 10.5 percent, respectively.

Again Wells Fargo does a fantastic job of breaking down all the calculations to arrive at both the common equity Tier 1 and Tier 1 capital. I am sure that is an attempt to be as transparent as possible, given its recent struggles with truthfulness.

To get more flavor of the breakdown by Wells Fargo, please check out the Capital Management section of its latest quarterly report.

If we look at another bank and searching for the data in the Capital Management section of the quarterly report on June 30, 2020, we find that Fifth Third Bank has the following ratios:

  • CET1 – 9.72%
  • Tier 1 Risk-based capital – 10.96%

If you take the time to look at Tier 1 for each and any bank, you will find different levels of disclosure in regards to this ratio. Many banks have no issue with capital requirements and won’t make a big deal about the levels.

As you can see, all banks will provide you with all the information to calculate both the Tier 1 capital ratio and the common equity Tier 1 ratio.

Is it important to be able to do this math yourself? Nope, but it is important to understand where the numbers come from and the idea behind the ratio and how it indicates the financial strength of a bank.

Tier 1 Capital Stats for the Banking Industry

Let’s look at a few stats to get an idea of how different leading banks stand compared to their peers when it comes to Tier 1 capital.

A few leading banks by Tier 1 capital, in billions:

  • JP Morgan – $204.69
  • Bank of America – $153.09
  • Wells Fargo – $147.54
  • Citibank – $136.92
  • US Bank – $41.84
  • Truist – $39.6

According to the New York Fed, the common equity Tier 1 ratio stands at 12.09 percent for the banking sector as a whole as of the end of the first quarter of 2020. Well above the pre-crisis level of 2001 to 2006 at 8.25 percent.

Here is a list of some of the common equity Tier 1 ratio for the leading banks:

  • JP Morgan – 11.48%
  • Bank of America – 10.77%
  • Citibank – 11.22%
  • Goldman Sachs – 12.54%
  • Morgan Stanley – 15.71%
  • Truist – 9.23%
  • Bank of New York Mellon – 11.33%
  • American Express – 11.85%

Final Thoughts

Determining the Tier 1 capital for any bank is a simple formula, especially since banks will provide you with the information. As mentioned before, it is not critical calculating this yourself; rather, it is important to understand the theory and use of the formula.

Banks were the scapegoat for the last financial crisis, and as a result, the Basel Accord created regulations that would help ensure that banks had enough capital to survive the next crisis.

As evidenced by the bank’s capital levels and ability to survive the current crisis, I would hazard that those regulations have helped preserve capital but also the public’s faith in banks, at least a little.

The big take away from today’s post is to understand Tier 1 capital and the impact it has on the bank’s liquidity and capital. It is also an easy way for investors to determine the strength of a bank in the coming of a crisis.

That is going to wrap up our conversation for today.

As always, thank you for taking the time to read today’s post, and I hope you find something of value on your investing journey.

If I can be of any further assistance, please don’t hesitate to reach out.

Until next time, take care and be safe out there,

Dave