LO 59.4: Define in the context of Basel III and calculate where appropriate:

LO 59.4: Define in the context of Basel III and calculate where appropriate: Tier 1 capital and its components Tier 2 capital and its components Required Tier 1 equity capital, total Tier 1 capital, and total capital
Basel III increased capital for credit risk and tightened the definition of capital in response to the 20072009 financial crisis. The proposals were published in December 2010 and will be implemented gradually between 2013 and 2019. Basel III eliminated Tier 3 capital.
Tier 1 capital (or core capital) includes: Common equity including retained earnings (called Tier 1 equity capital or Tier 1
Non-cumulative perpetual preferred stock (additional Tier 1 capital, part of total Tier 1
common capital).
capital).
Tier 1 capital does not include: Goodwill. Deferred tax assets. Changes in retained earnings arising from securitized transactions. Changes in retained earnings arising from the banks credit risk, called debit (debt) value
adjustment (DVA).
Tier 1 capital is adjusted downward to reflect defined benefit pension plan deficits (but is not adjusted upward for surpluses). In addition, there are rules governing capital issued by consolidated subsidiaries and also for the inclusion of minority interests.
Some preferred stock, such as cumulative perpetual preferred. Tier 2 capital (or supplementary capital) includes: Debt subordinated to depositors with an original maturity of five years or more.
Common equity is known as going-concern capital. It absorbs losses when the bank has positive equity (i.e., is a going concern). Tier 2 capital is known as gone-concern capital. When the bank has negative capital and is no longer a going concern, Tier 2 capital absorbs losses. Depositors are ranked above Tier 2 capital in liquidation so theoretically, as long as Tier 2 capital is positive, depositors should be paid in full.
Capital requirements for each tier and for total capital are: Tier 1 equity capital must be 4.5% of risk-weighted assets at all times. Total Tier 1 capital (i.e., equity capital plus additional Tier 1 capital such as perpetual
preferred stock) must be 6% of risk-weighted assets at all times.
Total capital (Total Tier 1 capital plus Tier 2 capital) must be at least 8% of risk-
weighted assets at all times.
By comparison, under Basel I the equity capital requirement was 2% of risk-weighted assets and the total Tier 1 capital requirement was 4% of risk-weighted assets. The new requirements are significantly more rigorous both because the percentages are higher and because the definition of what qualifies as equity capital has been tightened. The 8%
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Topic 59 Cross Reference to GARP Assigned Reading – Hull, Chapter 16
total capital requirement is the same as under Basel I and Basel II, but again, the stricter definition of equity capital applies under Basel III.
The timeline for implementation for new capital requirements is shown in Figure 2.
Figure 2: Implementation Dates for New Capital Requirements
Regulatory Change Tier 1 Equity Capital Tier 1 Total Capital New Capital Definitions
1/1/13 3.5% 4.5%
1/1/14 4.0% 5.5%
1/1/15 4.5% 6.0%
1/1/18 4.5% 6.0%
Phased in
Phased in
Phased in
New definitions fully in place
C a p i t a l C o n s e r v a t i o n B u f f e r a n d C o u n t e r c y c l
i c a l B u f f e r

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