Exploring Common Equity: Understanding a Key Financial Concept

Common Equity Tier 1 (CET1) is a fundamental component of a bank's Tier 1 capital, primarily consisting of common stock holdings. This regulatory framework was established in 2014, designed as a precautionary measure to safeguard the economy from financial crises, with a primary focus on the European banking system. It is crucial for all Eurozone banks to meet the minimum CET1 ratio requirements set by financial regulators, and in this article, we will delve into the intricacies of CET1. So, What is the meaning of a dissolution resolution for a company? ACC Group will address your question.

I. What is the definition of common equity?

Common equity, often referred to as "common stock" or "ordinary shares," is a type of ownership interest in a company, representing a form of equity capital. Common equity holders are the residual owners of a company, which means they have a claim on the company's assets and earnings after all other obligations, including debt and preferred stock, have been satisfied. Common equity holders typically have voting rights in the company, allowing them to participate in corporate decisions and elect members of the board of directors.

II. What Is Common Equity Tier 1 (CET1)?

Understanding Common Equity Tier 1 (CET1)

The roots of CET1 trace back to the Basel Committee, which introduced a set of international standards known as Basel III in response to the 2007-2008 financial crisis. Basel III seeks to assess and ensure the capital adequacy of banks by comparing their assets with their capital, a pivotal measure in determining their resilience during crises.

Capital plays a crucial role in a bank's ability to absorb unexpected losses that may arise during its regular operations. Basel III, in essence, tightens the requirements concerning the types of capital that banks can include in various capital tiers and structures.

The Three Tiers of Capital

A bank's capital structure is divided into three tiers, each with a specific purpose:

Tier 1 Capital

Tier 1 Capital, also known as going concern or core capital, is the cornerstone for funding a financial institution's day-to-day operations. It comprises two key components: Common Equity Tier 1 (CET1) capital and Additional Tier 1 (AT1) capital.

Tier 2 Capital

This category, often referred to as gone concern or supplementary capital, includes items like hybrid capital instruments and subordinated term debt. These instruments act as a secondary layer of protection for banks.

Tier 3 Capital

The third tier consists of capital that covers market risk, commodities risk, and foreign currency risk, and it is considered the lowest quality of the three.

CET1: The Highest Quality Capital

Common Equity Tier 1, often described as "the highest quality of regulatory capital," is the most critical component. It is the first to absorb losses when they occur. For a bank to meet regulatory standards, its Tier 1 capital must maintain a minimum ratio of 4.5% of CET1 concerning its Risk-Weighted Assets (RWAs).

Special Considerations

CET1's position at the bottom of the capital structure is significant because, in times of crisis, any losses are first deducted from this tier. If such deductions cause the CET1 ratio to fall below its regulatory minimum, the bank must take immediate action to rebuild its capital ratio. Failure to do so could result in regulatory intervention, potentially leading to the bank's closure or takeover.

During this rebuilding phase, regulators may impose restrictions on dividend payments and employee bonuses. In extreme cases, equity holders bear the brunt of losses initially, followed by hybrid and convertible bondholders, and finally, Tier 2 capital.

Stress Tests

To assess a bank's ability to weather a financial crisis, the European Banking Authority conducts stress tests using the CET1 ratio periodically. These tests simulate adverse scenarios to determine how much capital banks would retain in such conditions. Results from these tests have generally shown that most banks possess sufficient capital to withstand crises.

Calculating Common Equity Tier 1 (CET1) Capital

CET1 capital is calculated by combining Common Equity Tier 1 capital with Additional Tier 1 capital. CET1 capital encompasses a bank's core capital and includes common shares, stock surpluses resulting from the issuance of common shares, retained earnings, common shares issued by subsidiaries and held by third parties, and accumulated other comprehensive income (AOCI).

Additional Tier 1 capital, on the other hand, consists of instruments that, while not common equity, are eligible for inclusion in this tier. An example of AT1 capital is a contingent convertible or hybrid security, which can be converted into equity when a specified trigger event occurs. This conversion typically happens when CET1 capital falls below a specific threshold.

The CET1 ratio, an essential metric, measures a bank's capital against its assets. As different assets pose varying degrees of risk, they are weighted according to their credit risk and market risk. This weighting ensures that banks maintain a prudent level of capital in proportion to their risk exposure.

Common Equity Tier 1 Ratio = Common Equity Tier 1 Capital ÷ Risk-Weighted Assets

For instance, a government bond, considered a "no-risk asset," is assigned a zero percent risk weight, while a subprime mortgage, viewed as high-risk, may have a 65% risk weight. Basel III dictates that all banks must maintain a minimum CET1 to RWAs ratio of 4.5%.

In conclusion, Common Equity Tier 1 (CET1) is an integral part of the regulatory framework designed to fortify the banking sector against financial turmoil. Its role in absorbing losses and its strict regulatory requirements ensure that banks are well-prepared to face economic challenges, ultimately contributing to the stability of the financial system.