Common Equity Tier 1 (CET1)

Common Equity Tier 1 (CET1) capital is a core measure of a bank’s financial strength from a regulator’s point of view. This term was introduced as a part of the Basel III regulatory framework, which is a set of international banking regulations developed by the Basel Committee on Banking Supervision. The CET1 ratio measures a bank’s common equity capital against its risk-weighted assets to ensure that banks have sufficient capital to absorb losses.

What is CET1?

CET1 capital primarily consists of common shares and retained earnings. It represents the highest quality of regulatory capital, as it is fully available to absorb losses. CET1 is calculated by summing up common shares, stock surplus (resulting from the issue of common instruments including premium), retained earnings, and accumulated other comprehensive income (AOCI). From this, certain intangible assets like goodwill and regulatory adjustments are deducted.

The CET1 ratio is calculated by dividing the CET1 capital by the bank’s total risk-weighted assets (RWA). The formula looks like:

CET1 Ratio = (CET1 Capital / Risk-Weighted Assets) * 100

Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks to reduce the risk of insolvency. Various types of assets are weighted based on their risk, and the sum total is used in the calculation.

Significance of CET1

• Regulatory Requirement: CET1 is used by regulators to determine a bank’s ability to sustain itself during financial distress. Under Basel III, banks are required to maintain a minimum CET1 ratio of 4.5%. Banks are also subject to additional buffers like the capital conservation buffer (2.5%) and potentially a countercyclical buffer (up to 2.5%), bringing the total CET1 requirement up to 9.5%.

• Financial Stability: High CET1 ratios indicate that a bank is well-capitalized, which provides a cushion against financial losses and enhances long-term stability and confidence among investors and depositors.

• Market Confidence: A higher CET1 ratio generally leads to increased confidence among stakeholders, including investors, borrowers, and regulators. It shows that the bank has a strong equity base to support its lending and investment activities.

Components of CET1 Capital

Common Equity

• Common Shares: These are the primary units of ownership in a bank, providing investors with voting rights and entitling them to dividends.
• Stock Surplus: This refers to any excess amount received by the bank over and above the face value of the shares issued.

Retained Earnings

• Accumulated Profits: These include profits that are retained in the bank and not distributed to shareholders as dividends.
• Undistributed Profits: These refer to profits that have not yet been allocated by the bank for any specific purpose.

Accumulated Other Comprehensive Income (AOCI)

• Gains and Losses: This includes accumulated gains and losses that are not part of the regular net income, such as unrealized gains/losses on available-for-sale securities and foreign currency translation adjustments.

Regulatory Adjustments

• Goodwill: Intangible assets like goodwill are deducted from CET1.
• Deferred Tax Assets (DTAs): Some DTAs are also deducted based on regulatory guidelines.
• Minority Interest: Certain minority interests in banking subsidiaries may also be included or excluded based on regulatory considerations.

Calculation Example

To illustrate the computation of the CET1 ratio, consider a hypothetical bank with the following financials:

• Common Shares: $50 million
• Stock Surplus: $20 million
• Retained Earnings: $100 million
• AOCI: $10 million
• Goodwill: $15 million
• Risk-Weighted Assets (RWA): $700 million

First, calculate the CET1 capital:

CET1 Capital = Common Shares + Stock Surplus + Retained Earnings + AOCI - Goodwill

CET1 Capital = $50 million + $20 million + $100 million + $10 million - $15 million = $165 million

Now calculate the CET1 ratio:

CET1 Ratio = (CET1 Capital / Risk-Weighted Assets) * 100

CET1 Ratio = ($165 million / $700 million) * 100 ≈ 23.57%

In this example, the bank has a CET1 ratio of approximately 23.57%, indicating strong financial health.

Basel III and CET1

Basel III, formulated by the Basel Committee on Banking Supervision, aims to strengthen regulation, supervision, and risk management within the banking sector. One of the key elements of Basel III is the concept of CET1, which underscores the importance of high-quality capital.

Key Enhancements Under Basel III

• Higher Capital Requirements: Basel III increased the minimum regulatory capital requirements, mandating that banks hold a greater proportion of equity capital.
• Capital Buffers: Introduced buffers like the capital conservation buffer and countercyclical buffer that banking institutions must hold in addition to the minimum CET1 requirement.
• Leverage Ratio: Introduced a non-risk-based leverage ratio to serve as a backstop measure against excessive borrowing.
• Liquidity Standards: Introduced two liquidity ratios – the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) to ensure banks have sufficient liquidity during financial stress.

How Banks Manage CET1

Banks employ various strategies to maintain or improve their CET1 ratios, ensuring adherence to regulatory requirements and financial stability.

Capital Raising

• Issuing New Shares: Banks can issue new common shares to raise capital. This can dilute existing shareholders’ ownership but adds to the CET1 capital.
• Retained Earnings: Banks can increase their retained earnings by retaining a larger portion of their profits instead of paying them out as dividends.

Risk Management

• Reducing Risk-Weighted Assets: By re-allocating investments to lower-risk assets, banks can decrease their RWA, thereby improving the CET1 ratio.
• Diversification: Diversifying asset portfolios helps in spreading and potentially lowering risk.

Cost Management

• Efficient Operations: By optimizing operational efficiency, banks can reduce expenses and enhance profitability, contributing to higher retained earnings.
• Asset Sales: Banks can sell non-core or underperforming assets to reduce RWAs and improve capital ratios.

Real-World Examples

JPMorgan Chase

JPMorgan Chase, one of the largest banks in the United States, maintains a robust CET1 ratio. The bank’s strategy includes strong earnings retention, diversified investment portfolios, and risk management practices.

For more information: JPMorgan Chase

HSBC Holdings

HSBC, a global bank headquartered in London, focuses on maintaining a strong CET1 ratio through strategic capital allocations and managing RWAs. The bank also engages in regular stress testing to ensure its capital adequacy under various scenarios.

For more information: HSBC Holdings

Conclusion

Common Equity Tier 1 (CET1) is a critical measure of a bank’s financial health and stability. Mandated by regulatory frameworks like Basel III, CET1 serves as a buffer against financial distress and enhances confidence among stakeholders. In today’s complex financial systems, maintaining a robust CET1 ratio is essential for banks to navigate economic uncertainties and ensure long-term sustainability.