Common Equity Tier 1 (CET1)

Common Equity Tier 1 (also known as CET1) is the ultimate financial shock absorber for a bank. Think of it as the highest-quality, most reliable form of capital a bank holds to protect itself, its depositors, and the wider financial system from unexpected losses. If a bank hits a rough patch and its investments go sour, CET1 is the first layer of defense used to cover those losses. This capital is primarily made up of the most tangible and permanent sources of funding: the bank's common stock (money from shareholders) and its retained earnings (profits that have been reinvested back into the business over many years). To ensure its purity, “flimsy” accounting items like goodwill and other intangible assets are subtracted from the total. The CET1 concept was thrust into the spotlight by the Basel III international banking regulations, which were created after the 2008 financial crisis to build a more resilient banking sector. For any value investor analyzing a bank, understanding its CET1 position is a non-negotiable step in assessing its health and safety.

At first glance, CET1 might seem like a dry, technical term for regulators. However, for an ordinary investor, it’s one of the most important indicators of a bank's quality and risk. Here’s why you should care:

• A Barometer of Safety: A higher CET1 ratio signals a safer, more conservative bank. It's a direct measure of its ability to withstand a severe economic storm—like a recession or a housing market crash—without capsizing. A bank with a strong CET1 cushion can absorb significant losses and continue to operate, whereas a weakly capitalized bank could face insolvency.
• Protection for Your Investment: If a bank’s CET1 ratio falls below the minimum required by regulators, it triggers alarm bells. The bank will be forced to take corrective action, which is almost always painful for shareholders. This could involve issuing a flood of new shares at a low price (diluting your ownership stake) or slashing or eliminating its dividends. A bank with a consistently high CET1 ratio is far less likely to put you in that position.
• A Value Investing Litmus Test: When evaluating a bank stock, a value investor must look beyond simple metrics like the price-to-book value or earnings per share. A bank might look statistically cheap, but if its CET1 ratio is thin, you are likely buying hidden risk, not deep value. A healthy CET1 ratio is a fundamental prerequisite for a sound, long-term investment in any financial institution.

The formula itself is straightforward, but its components reveal how regulators force banks to be honest about their risk-taking.

The calculation is a simple division: CET1 Ratio = CET1 Capital / Risk-Weighted Assets (RWAs) This ratio tells you how much pure, loss-absorbing capital a bank has in relation to the overall riskiness of its loans and investments.

This is the numerator of the equation—the good stuff. It is designed to include only the most dependable forms of capital.

• The Core Components:
  • Common shares issued by the bank.
  • The bank’s retained earnings (its accumulated, reinvested profits).
• The Key Deductions:
  • Goodwill, intangible assets, and certain deferred tax assets are subtracted to ensure the capital figure isn't inflated by accounting entries that can't actually absorb losses.

This is the denominator and the clever part of the regulation. Instead of just looking at a bank’s total assets, regulators assign a “risk weight” to each asset based on its potential to lose value. This prevents a bank from appearing safe while secretly loading up on high-risk, high-return bets.

• Safe Assets: Cash or bonds issued by a highly-rated government (like the US or Germany) have a 0% risk weight. A $100 million holding of these bonds adds $0 to the bank's RWA calculation.
• Standard Assets: A typical residential mortgage might have a 35% or 50% risk weight. So, a $100 million portfolio of such mortgages would add $35 million or $50 million to RWAs.
• Risky Assets: An unsecured loan to a speculative company could carry a 100% or even 150% risk weight. A $10 million loan of this type could add $10 million or $15 million to the bank's RWAs.

This system brilliantly forces banks to hold more capital in reserve precisely when they are taking more risks.

Regulators like the Federal Reserve in the US and the European Central Bank in Europe set the official minimums. Under Basel III, the base minimum is 4.5%, but various mandatory buffers (like the Capital Conservation Buffer) effectively push the real-world requirement to over 7% for most banks. The largest, “systemically important” banks face even stricter requirements. As a prudent investor, however, you should look for a cushion well above these minimums.

• A Healthy Level: A CET1 ratio above 10% is a good sign, and a bank sporting a ratio of 12% or higher suggests a fortress-like balance sheet that can handle serious adversity.
• The Trade-Off: Is more always better? Not necessarily. An extremely high ratio (e.g., over 15%) might suggest the bank is being too conservative. It may be holding onto too much capital instead of deploying it to make loans and generate profits, which can drag down its return on equity (ROE).

The sweet spot for a great bank investment is a CET1 ratio that is comfortably above regulatory mandates but not so excessively high that it hinders the bank's ability to create value for its shareholders. It’s the perfect embodiment of the balance between risk and reward.