Common Equity Tier 1 (CET1) Capital

Common Equity Tier 1 Capital (often shortened to CET1 Capital) is the ultimate financial cushion for a bank. Think of it as a bank's core, high-quality rainy-day fund, designed to absorb unexpected losses and keep the bank afloat during tough times without needing a bailout. This capital primarily consists of the most dependable sources of funds: Common Stock issued by the bank and its Retained Earnings (profits that have been ploughed back into the business over the years). The concept was heavily reinforced by the Basel III international accords, a set of financial reforms developed in response to the 2008 financial crisis. Essentially, CET1 is the first line of defense, ensuring that the bank's own shareholders bear the brunt of any losses before depositors or taxpayers are put at risk.

For an investor, especially one following a Value Investing philosophy, CET1 is not just regulatory jargon; it’s a critical health metric. A bank’s strength and resilience are directly tied to the size of its CET1 cushion. As the legendary investor Warren Buffett famously quipped, “Only when the tide goes out do you discover who's been swimming naked.” A bank with a robust CET1 ratio is wearing a sturdy life vest, while one with a low ratio is exposed and vulnerable. A high CET1 ratio signals several positive traits:

• A Strong Margin of Safety: It means the bank can withstand significant financial storms before its solvency is threatened.
• Prudent Management: It suggests a conservative leadership team that prioritizes stability over reckless growth.
• Shareholder Protection: In a crisis, a well-capitalized bank is less likely to have to dilute existing shareholders by issuing new stock at bargain-basement prices just to stay alive.

For a value investor, analyzing a bank without checking its CET1 ratio is like buying a used car without looking under the hood. It’s a non-negotiable check on the long-term durability and quality of the institution.

While CET1 Capital is an absolute number, what investors and regulators really focus on is the CET1 Ratio. This ratio puts the capital figure into context by comparing it to the bank's overall risk exposure. The formula is straightforward: CET1 Ratio = CET1 Capital / Risk-Weighted Assets

This is the “highest quality” capital. The main components are:

• Common Stock: The money raised from selling shares on the stock market.
• Retained Earnings: The cumulative profits the bank has kept instead of paying out as Dividends.
• Other Comprehensive Income: Certain other equity accounts.

Crucially, regulators require banks to subtract “squishy” or unreliable items, such as Goodwill and most other intangible assets, to arrive at a pure, tangible capital figure.

Risk-Weighted Assets (RWAs) are a clever way to measure a bank's risk. Regulators know that not all assets are created equal. A loan to the German government is far safer than a loan for a speculative real estate project. So, the bank’s assets are “weighted” based on their credit risk.

• A super-safe asset like cash or a government bond might have a 0% risk weight, meaning it doesn't require any capital to be held against it.
• A standard mortgage might have a 35% risk weight.
• A corporate loan might have a 100% risk weight.

The bank's total RWA is the sum of all its assets multiplied by their individual risk weights. This system forces banks that take on more risk (i.e., have higher RWAs) to hold more capital.

Knowing the magic number is key to using this tool effectively.

• Regulatory Minimum: Under Basel III, the absolute minimum CET1 ratio is 4.5%. However, this is like the minimum score needed to not fail a class—you’d never want to be that close to the line.
• The Real-World Minimum: Regulators require banks to hold extra buffers on top of the 4.5%. The main one is the Capital Conservation Buffer of 2.5%, which brings the effective minimum for most major banks to 7%. Banks that are deemed “systemically important” must hold even more.
• An Investor's Benchmark: A prudent value investor should look for banks that comfortably exceed these regulatory hurdles. A CET1 ratio above 10% is generally considered solid, and many of the world's most stable banks operate with ratios of 12% or higher. A consistently high and stable ratio is a hallmark of a fortress-like Balance Sheet. While an excessively high ratio might suggest the bank is not deploying capital efficiently, for a value investor, an abundance of safety is rarely a bad thing.