The Tier 1 capital ratio compares the core equity capital of a banking entity to its risk-weighted assets. The ratio is used by bank regulators to assign a capital adequacy ranking. A high ratio indicates that a bank can absorb a reasonable amount of losses without risk of failure. The rankings used are:
- Well capitalized
- Adequately capitalized
- Significantly undercapitalized
- Critically undercapitalized
The formula for the Tier 1 capital ratio is:
Core equity capital ÷ Risk-weighted assets
The "Tier 1" name in the numerator of the ratio refers to the core equity capital of a banking institution, and includes the following types of capital:
- Common stock
- Retained earnings
- Disclosed reserves
- Non-redeemable, non-cumulative preferred stock
The risk-weighted assets in the denominator are comprised of all assets held by the entity that are weighted for their credit risk. This weighting scale differs by asset classification. For example, bills and coins are assigned no risk, while a letter of credit is assigned a higher level of risk.
In order to attain a top-tier "well capitalized" score, a banking institution must have a Tier 1 capital ratio of at least 6% and meet certain other requirements related to the impact of its dividends and distributions on its capital. At the other end of the range, a critically undercapitalized entity has a capital ratio of worse than 4%. Banking institutions scoring as undercapitalized (or worse) cannot issue dividends or pay management fees, and must prepare and file a capital restoration plan to improve their score.