By: Ryan C. Fuhrmann, CFA
By mid-2009, years of unsustainable housing price appreciation had caused what in hindsight may be considered the biggest credit bubble in history. Banks are frequently caught up in the middle of financial debacles, and that specific crisis has been no exception. Therefore, it has become vitally important to differentiate between those who will succumb to the crisis and go bankrupt or become nationalized by the government from those that will survive and come out even stronger once conditions inevitably improve. An important measure is determining a bank´s capital adequacy ratios, with theTier 1 capital ratio front and center as governments decide who needs rescuing and investors look to profit from an uneven environment.
Tier 1 Capital Ratio Background
The Tier 1 capital ratio stems from a framework created by the Basel Committee, which was established in the 1970s by the Group of Ten (G10) industrialized nations shortly after a complicated bank liquidation. The Committee meets regularly and serves as a way for top-member central banks across the world to coordinate global banking oversight and regulation. Part of this process includes publishing research to serve as a guide to other regulatory bodies. The Basel Accords are among the most highly recognized.
The Basel I was published in 1988 and updated extensively in 2004 when Basel II was released. As you might imagine, the accords are quite extensive and cover many regulatory topics, but the primary motivation is to provide a minimum standard for capital adequacy for banks to provide an acceptable cushion and protect against potential loan and other losses. A key part of this standard is to break capital into two Tiers, the first of which is Tier 1 capital.