What Is the Connection Between Common Stock and Tier 1 Capital?

Tier 1 capital is also called "core capital". According to the nature and functions of bank capital, the division of the different components that constitute bank capital is the most important part of bank assets. In 1981, the standard originally formulated by three US federal regulatory agencies (Monetary Supervisor of the Treasury, Federal Reserve System, and Federal Deposit Insurance Corporation): Tier 1 capital consists of common shares, preferred shares, capital premium, undistributed profits, convertible It is made up of stock bonds, bad debt reserves and other capital reserves. The ratio of Tier 1 capital to total assets varies by region, but the minimum must not be less than 5%. In this way, the bank can bear a certain amount of bad debt losses, and maintain the bank's stable operation and normal profitability. In January 1987, the United States and Britain jointly proposed a weighted assessment of the capital adequacy of the banks of the two countries based on tier 1 capital and tier 2 capital, so that the banks of the two countries could compete on an equal basis. Became the international standard for bank capital suitability under the Basel Accord. ^[1]

Tier 1 capital

Tier 1 capital includes core Tier 1 capital and other Tier 1 capital.

Core Tier 1 capital includes:

(1) Paid-up capital or common stock.

(2) Capital reserve.

(3) Surplus reserve.

(4) General risk provisions.

(5) Undistributed profits.

(6) Minority shareholders' capital may be included in part.

Other Tier 1 capital includes:

(1) Other Tier 1 capital instruments and their premiums.

(2) Minority shareholders' capital may be included in part. ^[2]

Replenishing core capital is the most fundamental means for commercial banks to improve their ability to resist risks: the supervisory authorities have not relaxed the conditions for issuing subordinated debt, and the credit limit of subordinated debt is directly related to core capital. The space for debt to supplement subsidiary capital is also greater, so supplementing core capital is the most fundamental means for commercial banks to improve their ability to resist risks. This is why listed city commercial banks with abundant core capital are hardly affected by this new regulation. We also believe that the core capital adequacy ratio of 7% has become the actual CCAR standard.

The ultimate impact on commercial banks is reflected in the reduction of leverage multiples, but long-term ROE does not necessarily decrease: We estimate that the current 10% capital adequacy ratio will remain unchanged, and the proportion of debt instruments included in subsidiary capital will be reduced from 50% to 25 %, Will reduce the industry's maximum leverage ratio from about 27 times to about 23 times, and the decline in leverage will lead to a reduction in long-term ROE levels. However, we should also see that commercial banks' vigorous development of intermediate businesses that do not consume capital and the development of retail businesses that consume less capital can effectively improve ROA. The long-term ROE level does not necessarily decrease with the reduction of leverage. In addition, there is still plenty of room for banks to adjust their asset structure, so reducing risk weights is also an important way to increase capital adequacy ratios.

Tier 1 capital calculation formula

Core capital adequacy ratio = (core capital / total weighted risk assets) × 100%

The Basel Agreement stipulates that the capital adequacy ratio of the signatory country must reach 8%, that is, the minimum capital limit of the bank is 8% of the bank's risk assets, and the core capital adequacy ratio of 5%, that is, the core capital cannot be lower than 5% .

Tier 1 capital composition

Core capital is the self-owned funds that financial institutions can use and control forever, and its composition is as follows:

(1) Paid-up capital. Paid-in capital refers to common shares and permanent non-cumulative preferred shares that have been issued and fully paid up, which are permanent shareholders' equity. Including state capital, corporate capital, personal capital, foreign capital

(2) Capital reserve

(3) Surplus reserve

(4) Undistributed profits. The net profit realized by the enterprise after making up losses, withdrawing surplus reserves and distributing profit to investors will be retained in the company's profit accumulated over the years.

(5) Open reserves. Including stock issuance premium, retained profits, general reserve and appreciation of statutory reserve, etc.