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 financial capital which is considered to be the most reliable and liquid, thus primarily Shareholders' equity. Examples of Tier 1 capital are common stock and open reserves, preferred stock that is irredeemable and non-cumulative, and retained earnings.

The concept of tier 1 as well as 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.

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 which cover 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, weighted for credit risk according to the Regulator (usually the country's Central Bank). Most Central Banks follow the BIS - Bank of International Settlements - 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%.

Tier 1 capital ratio: Core Equity Capital / Risk Weighted Assets