Tier 1 or core capital It is a ratio that is used to measure the strength of a bank. It is made up of the basic capital, consisting mainly of ordinary shares. It may also include perpetual preferred shares and other investments of the bank.
The Tier 1 ratio is therefore the ratio of a bank's share capital to all of its risk-weighted assets. This quotient will provide us with a good approximation of the strength of the banks.
Therefore, the formula for its calculation is the following:
Tier 1 = Risk-weighted Equity / Assets
How an entity can improve Tier 1 capital
The Tier 1 of a bank can be increased in two possible ways:
- Through a capital increase: It is the best option to strengthen a bank against possible risks. True equity is expanded through shareholders. It has the disadvantage that it reduces the profit and the dividend per share.
- Through the issuance of preferred shares: A kind of shares are issued without voting rights. It is a very limited instrument that generates mistrust among consumers.
Basel III and Tier 1
The Basel III agreement obliges banks to increase their capital reserves to be protected against possible falls. This document also called for a greater capacity to absorb losses through equity instruments.
Thus, Basel III implies that the minimum Core Capital must increase to 7%. Minimum levels are also required in capital categories such as Additional Tier 1 at 1.5%, while Tier 2 should not be less than 2%.
On the other hand, 2.5% anti-cyclical capital buffers will be required that can be used in periods of economic recession. This measure should be carried out gradually between 2016 and 2018.