Tier 1 capital

Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It consists of the types of financial capital considered the most reliable and liquid, primarily Shareholders' equity. Examples of Tier 1 capital are common stock, preferred stock that is irredeemable and non-cumulative, and retained earnings.

Capital in this sense is related to, but different from, the accounting concept of shareholder's equity. Both tier 1 and tier 2 capital were first defined in the Basel I capital accord. The new accord, Basel II, has not changed the definitions in any substantial way.

Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems.

The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses—provisions, reserves, and current year profits are for expected losses.

More specifically, Tier 1 Capital is a measure of capital adequacy of a bank, and is the ratio of a bank's core equity capital to its total risk-weighted assets. Risk weighted assets is the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country's Central Bank). Most Central Banks follow the BIS - Bank of International Settlements [1] - guidelines in setting asset risk weights. Assets like cash and coins usually have zero risk weight, while unsecured loans might have a risk weight of 100%.

It is calculated as:

Core Equity Capital / Risk Weighted Assets