Tier one capital is the core measure of a bank’s financial strength. It is composed of core capital, which consists primarily of common share and disclosed reserves, but may also include non-redeemable and non-cumulative preferred share.
Tier one capital represents a bank’s most reliable and liquid assets that can be tapped, if necessary. The use of tier one capital in evaluating a company’s financial health is helpful because it is a measure of liquid assets and provides a degree of confidence both to regulators and investors.
It’s a ratio regulators use to gauge strength with a 6% minimum floor required under Basel 2 agreement. By law, banks are required to maintain a certain level of tier one capital on their balance sheet. A tier one capital ratio of more than 15% implies that a company is conservative and prudent with its spending and capital reserves.
Technically, tier one capital ratio is made by dividing a firm’s tier one capital by its risk weighted assets. A firm’s risk-weighted assets include all assets that the firm holds that are systematically weighted for credit risk, meaning that each asset is assigned a weighted according to their risk level.
In some cases, a tier one ratio can be a deceiving measure of a company’s financial strength. This is because, in addition to the equity capital and disclosed reserves, there can be other hidden assets not reported on a balance sheet. Watch out for financial shenanigans!