Tier 1 capital consists of shareholders' equity and retained earnings.
Tier 1 capital is intended to measure a bank's financial health and is used when a bank must absorb losses without ceasing business operations.
Under Basel III, the minimum tier 1 capital ratio is 6%, which is calculated by dividing the bank's tier 1 capital by its total risk-based assets.
For example, bank ABC has $600,000 in equity and retained earnings and has $10 million in risk-weighted assets. Its tier 1 capital ratio is 6% ($600000/$10 million), which meets the minimum Basel III requirement.
Tier 2 Capital:
Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves.
Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital.
In 2015, under Basel III, the minimum total capital ratio is 8%, which indicates the minimum tier 2 capital ratio is 2%, as opposed to 6% for the tier 1 capital ratio.
For example, bank ABC has tier 2 capital of $100,000 and risk-weighted assets of $10 million. Therefore, the tier 2 capital ratio is 1% ($100000/$10 million). Thus, bank ABC's total capital ratio is 7% (6%+1%). Under Basel III, bank ABC would not meet the minimum total capital ratio of 8%.
Capital Adequacy Ratio (CAR)
Capital Adequacy Ratio (CAR), also known as Capital to Risk (Weighted) Assets Ratio (CRAR) is the ratio of a bank's capital to its risk.
National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss and complies with statutory Capital requirements.
It is a measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures.
This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.
Two types of capital are measured: Tier one capital, which can absorb losses without a bank being required to cease trading, & Tier two capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
Risk Weighted Asset (Also referred to as RWA)
Risk-weighted asset ( also referred to as RWA) is a bank's assets or off-balance-sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution.