In my last two articles we looked at the Liquidity Coverage Ratio and Net Stable Funding Ratio. These are important liquidity standards and the leverage ratios they give us combine with the Core Tier 1 ratio (CET1) to give us an overall view of Funding Risk.
As you know, these ratios and standards are a result of the financial crisis in 2007 and the ratios, if they are not maintained, may lead to a downgrade of credit ratings, failure to meet regulatory requirements and, most importantly, an inability to support the bank’s activities.
So, what is the Core Tier 1 (CET1) Ratio? In simple terms it is the good stuff on the balance sheet – retained earnings and common equity, which are then divided by risk weighted assets (RWA). If the bank has a large enough capital cushion, as shown by the ratio, the theory is that it will be able to survive an economic downturn.
At a high level, the calculation is straightforward. The bank’s capital is the numerator and the denominator is the bank’s assets recalculated, taking into account the varying levels of risk they inherently have. As a simple example:
A bank has $1,000 equity. It has $10,000 in liabilities (i.e. deposits) and it then lends the $10,000, which then becomes an asset. If we assume a risk weighting of 80%:
RWA = 80% X $10,000 = $8,000.
The CET1 is therefore $1,000 (equity) / $8,000 (RWA) = 12.5%
The new requirement for CET1 is 7% of RWA, and this must be achieved by 2018. As this is happening, the rules on what can be classified as Core Tier 1 are narrowing and the weightings applied to assets are increasing, thereby applying pressure to the numerator and denominator.
More details on Core Tier 1 can be found here: BIS – CET1
In my next article, we will consider a banks total capital considerations.
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