Common Equity Tier 1Edit

Common Equity Tier 1 (CET1) is the cornerstone of modern bank capital, designed to ensure that lenders can absorb losses without triggering taxpayer bailouts. At its core, CET1 represents the most reliable and loss-absorbing form of capital a bank can hold: primarily common shares that can be written down or wiped out only after all other liabilities have been exhausted. This makes CET1 the buffer that underpins confidence in the financial system and supports prudent, market-driven lending.

The CET1 ratio is calculated by dividing a bank’s CET1 capital by its risk-weighted assets. The more CET1 a bank holds relative to the risk it takes on, the more resilient it is to downturns. In practice, this framework ties together capital strength, lending capacity, and the incentives that drive prudent risk management. By elevating the cost of failures and constraining risk-taking to match available capital, CET1 aligns the interests of shareholders, creditors, and the broader economy. See also Basel III and regulatory capital.

This article explains CET1 from the perspective of financial discipline and stability, with attention to the rules that determine what counts as CET1, how banks are required to hold it, and what that means for lending, investment, and economic performance. For readers seeking broader context, related topics include risk-weighted assets, common shares, and retained earnings.

What is Common Equity Tier 1?

Common Equity Tier 1 is the highest-quality tier of capital in the Basel framework. It largely comprises common stock that is fully paid in and freely available to absorb losses, plus retained earnings and certain reserves. Unlike other forms of capital, CET1 is designed to be the first line of defense against losses and the last capital that can be deployed before a bank becomes insolvent.

Under the Basel framework, items that can count toward CET1 are carefully defined. Intangible assets such as goodwill are largely deducted from CET1 (they do not provide reliable, loss-absorbing capacity in a downturn). Non-controlling interests and other elements may be treated as non-CET1 capital or subject to deductions. This creates a focus on the most durable, loss-absorbing resources the bank truly has at its core. See Basel III, intangible asset, and goodwill for background on these rules.

Components and calculation

CET1 capital is composed mainly of: - Common shares that are freely available to absorb losses. - Retained earnings and accumulated other comprehensive income (AOCI) that are robust enough to be used to cover losses. - Regulatory adjustments and deductions required by the framework.

The CET1 ratio is computed as: CET1 ratio = CET1 capital / risk-weighted assets

Risk-weighted assets reflect the riskiness of a bank’s assets, with different assets assigned different weights based on regulatory judgments about credit, market, and operational risk. A higher CET1 ratio signals greater loss-absorption capacity relative to risk, and hence greater resilience in stress scenarios. For more on this concept, see risk-weighted assets and regulatory capital.

Regulatory framework and minimums

Basel III sets out minimums and buffers intended to strengthen banks’ resilience. The core minimum CET1 ratio is 4.5%, but this is complemented by a capital conservation buffer of 2.5%, bringing the effective minimum to 7% prior to any additional charges or adjustments. Beyond this, banks designated as global systemically important banks (G-SIBs) face extra buffers, and jurisdictions may apply countercyclical buffers during periods of excess credit growth. See Capital conservation buffer, Global Systemically Important Bank, and countercyclical capital buffer for details. National regulators translate these international standards into local requirements and supervisory expectations, and many banks hold higher CET1 levels to reflect local conditions and risk profiles.

How CET1 affects banks and the real economy

Stability and resilience: A strong CET1 base reduces the likelihood of distress during economic downturns, which in turn lowers the probability of taxpayer-funded rescue scenarios and protects public finances. See stress tests and regulatory capital for related concepts.
Lending behavior: Higher CET1 requirements raise the cost of capital and can influence banks’ willingness to take on risk. In practice, this can modestly restrain lending growth or shift composition toward higher-quality borrowers, while also encouraging more conservative terms on new lending.
Profitability and returns: The cost of maintaining CET1 capital can pressure return on equity (ROE). Banks respond by seeking efficiency, pricing discipline, and prudent risk management. See return on equity and Basel III for context.

Controversies and debates

From a pro-market, fiscally prudent perspective, CET1 rules are designed to prevent destructive risk-taking and to avoid another round of bailouts. Critics, however, argue that:

Credit access and economic growth: Some contend that heavy CET1 requirements can curb lending to small businesses or start-ups, potentially slowing job creation and growth in certain cycles. Proponents counter that the stability benefits—reduced crisis probability and lower systemic risk—outweigh short-term lending constraints.
Complexity and leverage: The Basel framework is intricate, with many deductions and adjustments that can obscure what the actual capital position means in practice. Critics say simpler metrics could achieve similar resilience with less regulatory overhead.
Asset risk weighting: Since risk-weighted assets depend on internal models and supervisory judgments, there is debate about whether the weights accurately reflect true risk. Advocates argue that risk sensitivity helps allocate capital to the riskiest activities, while detractors point to potential distortions and procyclicality.
Intangibles and loss absorption: The deduction of intangible assets from CET1 is a point of contention. Supporters say this prevents overstatement of true loss-absorbing capacity, while critics claim it can understate a bank’s real strength in today’s asset-light business environment.
“Woke” or politically colored critiques: Some critics frame capital requirements as barriers to growth or as government overreach. From a free-market standpoint, the core argument is that robust capital reduces moral hazard, protects taxpayers, and creates a more stable investment climate. Critics who describe capital rules as anti-growth often overlook the empirical evidence that well-capitalized banks weather crises more effectively and that social costs of bank failures—including potential taxpayer liability—are high.

In short, CET1 is about balancing the need for strong, loss-absorbing capital with the desire to keep credit flowing to productive parts of the economy. The right balance aims to prevent speculative blowups while preserving the incentive and ability of banks to finance households and firms. For more on these tensions, see financial regulation, Basel III, and capital adequacy ratio.

Global landscape and trends

Across major economies, CET1 and related Basel III standards have been adopted with variations in timing and specific buffers. The European Union, the United States, the United Kingdom, and other jurisdictions implement CET1 requirements through local regulators and supervisory authorities, while maintaining overall alignment with international standards. The shifting mix of capital, the pace of adoption, and the stringency of buffers influence how banks price risk, manage capital, and allocate lending. See Basel III and regulatory capital for context, and capital adequacy ratio for a comparative metric.

In the global system, the emphasis on CET1 reflects a preference for resources that can withstand shocks without immediate external support. This is paired with ongoing reforms in related areas, such as liquidity requirements and leverage ratios, to create a more resilient banking system. See leverage ratio and liquidity coverage ratio for related concepts.