Regulatory Capital Tiers
Bank regulators don't treat all capital as equally loss-absorbing — they sort it into tiers by how reliably it can absorb losses without the bank collapsing.
Prerequisites: Risk-Weighted Assets
Not every dollar on a bank's balance sheet labeled "capital" would actually be there to absorb losses in a crisis. Common shares issued to shareholders can be written down to zero without triggering a default. Some forms of subordinated debt convert to equity or get written off only under specific stress triggers. Regulators sort all of this into capital tiers, ranked by how reliably and how immediately each layer can absorb losses.
Capital tiers rank a bank's loss-absorbing resources from best (common equity, which absorbs losses first and always) to weaker (subordinated debt, which absorbs losses only in specific circumstances) — and regulatory minimums are set separately for each tier.
The tiers, from strongest to weakest
- Common Equity Tier 1 (CET1). Common shares and retained earnings. The purest form of capital — it absorbs losses immediately, has no fixed repayment obligation, and no maturity.
- Additional Tier 1 (AT1). Instruments like perpetual contingent convertible bonds ("CoCo bonds") that convert to equity or get written down when a trigger, such as CET1 falling below a threshold, is breached.
- Tier 2. Subordinated debt with a fixed maturity, ranking behind depositors and senior bondholders in a wind-down, but ahead of Tier 1 and equity holders.
Each tier has its own minimum ratio relative to risk-weighted assets, and the minimums stack — a bank needs enough CET1 on its own, and enough CET1 plus AT1 combined, and enough of all three tiers combined, all measured against RWA.
Worked example
A bank has $1,000 of risk-weighted assets and holds CET1 of $70, AT1 of $20, and Tier 2 of $15, giving ratios of 7% CET1, 9% Tier 1 (CET1 + AT1), and 10.5% total capital. If the regulatory minimum for CET1 alone is 4.5%, the bank passes on CET1. But if a stress test projects losses that would push CET1 down to $35 — a 3.5% ratio — the bank fails the CET1 minimum even though its total capital ratio, boosted by AT1 and Tier 2, might still look adequate on paper.
What this means in practice
The tiering matters most under stress, because it's designed to force losses onto shareholders and AT1 holders before depositors or senior creditors are touched. This is also why regulators layer additional CET1-specific buffers — the capital conservation buffer, the countercyclical buffer, buffers for globally systemic banks — on top of the bare minimum: CET1 is the tier regulators trust most, so it's the tier held to the highest additional standard.
A healthy total capital ratio can mask a weak CET1 position if a bank has leaned heavily on AT1 and Tier 2 issuance. Regulators and analysts look at each tier's ratio individually, not just the combined total, precisely because the tiers are not interchangeable in a real crisis.
Further reading
- Basel Committee, 'Basel III: A Global Regulatory Framework'