The types of capital securities issued by banks can be confusing even to sophisticated market players, but it’s important to understand how these differ from one another and how they can be used to test a bank’s ability to endure financial distress.
The types of capital securities issued by banks and the jargon that comes along with these can confuse anyone – even people with a business degree or those working in the financial industry.
But it’s important to understand the basics of a bank’s capital securities, which include Common Equity Tier 1 capital (CET1), Tier 1 capital (T1), Tier 2 capital (T2) and Total capital, because these are used by bank regulators to measure what’s called “capital adequacy ratios.”
The capital adequacy ratios (such as a CET1 ratio, T1 ratio, T2 ratio and total capital ratio) are used to assess whether or not a bank has sufficient capital on its balance sheet to endure financial distress. Senior debt is not part of capital securities.
From an investor’s perspective, capital securities are riskier than senior debt in terms of deferability of interest payments (or dividends) and ranking (or recovery) given default, so they typically come with higher returns.
Among capital securities, CET1 is considered the riskiest, followed by Additional T1, and T2. The flipside of that risk is that CET1 is the capital security that comes with the highest return.
Types of Securities
The major components of Common Equity Tier 1 capital, or CET1, are a bank’s common shares and retained earnings. In the regulatory regime, CET1 is a bit more complicated and is calculated as a bank’s common shareholders’ equity (which includes common shares and retained earnings) minus goodwill, intangible assets and other regulatory capital adjustments. The bank’s CET1 could be increased either by positive net income attributable to the bank’s common shareholders, which will improve retained earnings, or by issuing more common shares.
Tier 1 capital is the sum of CET1 and Additional Tier 1 capital. The major component of Additional Tier 1 capital includes preferred shares. NVCC preferred shares, non-NVCC preferred shares and T1 eligible hybrid securities all belong to this Additional Tier 1 capital bucket.
NVCC refers to “Non-Viability Contingent Capital” features, which allow a bank regulator to trigger an automatic conversion of capital securities to common shares if the bank regulator thinks a bank is no longer viable.
In Europe, contingent convertible capital instruments (CoCos) offer a similar concept as CoCos convert to common shares. They can be written down to zero if and when the certain pre-specified distressed conditions occur.
Tier 2 capital consists of NVCC subordinated debt and non-NVCC subordinated debt. Some may distinguish perpetual subordinated notes by calling them “Upper Tier 2” from fixed-maturity dated subordinated notes called “Lower Tier 2.” Given the permanency in the capital structure, Upper Tier 2 is considered more equity-like than Lower Tier 2.
Total Capital is the sum of Tier 1 and Tier 2 capital. It consists of CET1, Additional Tier 1 capital and Tier 2 capital.