Tier 1 capital

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Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It consists primarily of shareholders' equity but may also include 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 and remained substantially the same in the replacement Basel II accord.

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 which are covered by provisions, reserves and current year profits.

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets. Risk-weighted assets are 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 Bank of International Settlements (BIS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%.