Tier 1 capital

Capital in this sense is related to, but different from, the accounting concept of shareholders' 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. Tier 2 capital represents 'supplementary capital' such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt. Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation, because the legal framework varies in different legal systems. The theoretical reason for holding capital is that it should provide protection against unexpected losses. This is not the same as expected losses, which are covered by provisions, reserves and current year profits. In Basel I agreement, Tier 1 capital is a minimum of 4% ownership equity but investors generally require a ratio of 10%. Tier 1 capital should be greater than 150% of the minimum requirement. The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets (RWA). Risk-weighted assets are the total of all assets held by the bank weighted by credit risk according to a formula determined by the Regulator (usually the country's central bank). Most central banks follow the Basel Committee on Banking Supervision (BCBS) guidelines in setting formulae for asset risk weights. Assets like cash and currency usually have zero risk weight, while certain loans have a risk weight at 100% of their face value. The BCBS is a part of the Bank of International Settlements (BIS). Under BCBS guidelines total RWA is not limited to Credit Risk. It contains components for Market Risk (typically based on value at risk (VAR) ) and Operational Risk. The BCBS rules for calculation of the components of total RWA have seen a number of changes following the Financial crisis of 2007–08.