Tier 1 capital refers to capital that must be held by banks to meet regulatory requirements and is a broad indicator of a bank's financial strength and ability to sustain potential future losses.
Capital adequacy requirements are a key measure of prudential supervision in Australia and ADIs, including banks, must meet minimum regulatory requirements determined by APRA to set aside capital to ensure ongoing viability. Whilst the following discusses Australian banks, it is generally applicable to insurance companies (substitute deposit holders for insurance claim holders) and financial institutions domiciled in Europe, which operate under very similar principles.
Each level of regulatory capital (starting with Lower Tier 2, moving down the list), requires more onerous terms and conditions for the fixed income securities to satisfy APRA's requirements.
Tier 1 capital, which contributes to regulatory capital, must satisfy the following characteristics:
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Provide permanent and unrestricted commitment to funds
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Freely available to absorb losses
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Coupon payments or charges must be able to be deferred
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Rank behind claims of depositors and other creditors in the event of a winding-up
Tier 1 capital can be divided into:
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Fundamental Tier 1 capital (the highest form of capital) and includes: Paid-up ordinary shares, general reserves (excluding any general reserve for credit losses, which is included in Upper Tier 2 capital), retained earnings, current year earnings, foreign currency translation reserve, capital profits reserve (realised gains on disposal of revalued assets that have not been transferred from asset revaluation reserves into retained earnings) and minority interests arising from consolidation of Tier 1 capital of subsidiaries.
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Residual Tier 1 capital, all other components qualifying for Tier 1 status are divided into:
o Non-innovative residual Tier 1 capital comprising perpetual noncumulative preference shares
o Innovative Tier 1 capital which comprises all other Tier 1 instruments that satisfy the relevant criteria.
It is important to note that proposed Basel III changes will likely see the calculation and definition of various Tier 1 instruments change over coming years. However, existing Tier 1 issues are expected to remain in the marketplace under “grandfathering” rules.