Tier one equity; core tier one equity; common equity; tangible common equity – too many ways to count bank capital are carelessly thrown around. Problems are amplified by a lack of agreed standards while banks choose definitions that show themselves in the best light. The Basel Committee on Banking Supervision is supposedly days away from deciding new rules. A clear understanding of bank capital, therefore, is essential.
The amount of capital banks have matters as they take on far more leverage than the average steel-maker. This is because (although it is uncouth to say so) bank losses tend to be very small – even when the sector melts down – relative to total assets. That is why everyone wants to know how much loss-absorbing (equity-like) capital can be depleted before a bank actually goes kaput. The question then is: which stuff is exactly loss-absorbing?
The widest definition of capital for regulatory purposes includes both tier one and tier two capital. Tier one is common and preferred equity as well as any disclosed reserves. Tier two capital throws in undisclosed and loan-loss reserves, revaluation accounts and other quirky debt and hybrid securities. Some bits of tier two are equity-like but other bits seem too much like debt to count – that is, they have to be paid back and rank above common equity. Many investors, therefore, choose to ignore tier two assets completely. Equally, in normal circumstances goodwill and intangibles in tier one are genuine assets. In a crisis, both seem flaky.