Common Equity Tier 1 (CET1) Capital

Common Equity Tier 1 (CET1) Capital is the highest-quality, most loss-absorbing form of a bank's capital. Think of it as the financial bedrock of a bank—the core foundation that supports the entire structure. Introduced by the Basel III international regulatory framework after the 2008 financial crisis, CET1 is designed to ensure banks can withstand severe economic shocks without needing a taxpayer bailout. It primarily consists of a bank's common stock (the money raised from shareholders) and its retained earnings (the cumulative profits reinvested in the business over many years). Unlike other forms of capital that might have strings attached, CET1 capital is pure, permanent, and carries no obligation to be paid back. It's the first line of defense, ready to absorb losses immediately, allowing the bank to continue operating even in a deep recession. For investors, it's the single most important measure of a bank's resilience and financial strength.

For a value investor, analyzing a bank without looking at its CET1 capital is like buying a car without checking its brakes and airbags. It’s the ultimate measure of safety. A bank with a robust CET1 position is a fortress, while one with a thin capital base is a house of cards waiting for a gust of wind. Here’s why it’s your best friend when analyzing a bank stock:

• It's a buffer against disaster: A high CET1 level means the bank can absorb significant losses on its loans and investments before its solvency is threatened. This protects shareholders from being wiped out during an economic downturn.
• It enables opportunity: In a crisis, well-capitalized banks don't just survive; they thrive. They can continue lending when others can't, gain market share, and even acquire weaker competitors at bargain prices.
• It reduces the risk of dilution: A bank with weak capital may be forced to issue new shares at fire-sale prices during a panic to stay afloat. This severely dilutes the ownership stake of existing shareholders. A strong CET1 position makes this scenario far less likely.

In short, a strong CET1 capital base is a bank's Margin of Safety. It’s the cushion that protects your investment from the inevitable bumps and crises of the economic cycle.

While the absolute amount of CET1 capital is important, what matters more is its size relative to the bank's risks. This is measured by the CET1 Ratio. It's a simple-looking formula with a lot of depth. CET1 Ratio = CET1 Capital / Risk-Weighted Assets (RWAs) Let's break that down:

1. CET1 Capital (the numerator): As we've discussed, this is the bank's core equity capital—the good stuff.
2. Risk-Weighted Assets (RWAs) (the denominator): This is the clever part. Instead of just using a bank’s total assets, regulators assign a “risk weight” to each asset. A loan to a blue-chip company or a government bond has a low risk weight, while an unsecured credit card loan has a very high one. This forces banks to hold more capital against their riskiest activities. For example, a bank might need 8 cents of capital for every dollar of a risky corporate loan, but almost nothing for a dollar of U.S. Treasury bonds.

Regulators set minimum CET1 ratios (e.g., 4.5% under Basel III, plus additional buffers), but prudent investors look for banks that maintain a level significantly above these minimums. A ratio above 10% is often considered a sign of a well-capitalized and conservatively managed institution.

To understand CET1, you need to know what counts—and what doesn't. Regulators are extremely strict about this.

• Common Stock: The value of shares issued to the public.
• Retained Earnings: The powerhouse of capital generation. This is the accumulated mountain of profits that the bank has earned and chosen to reinvest over its entire history, rather than paying out as dividends. A large retained earnings balance is a testament to a long-term, profitable business.
• Additional Paid-in Capital: The amount investors paid for stock over and above its stated par value.
• Accumulated Other Comprehensive Income (AOCI): An accounting bucket for specific unrealized gains and losses on certain investments and pensions.

Regulators force banks to subtract assets whose value could prove illusory during a crisis. The goal is to arrive at a pure, tangible measure of loss-absorbing capital.

• Goodwill and other intangible assets: You can't pay depositors with a brand name or a customer list, so these are subtracted entirely.
• Deferred Tax Assets: These assets rely on future profitability to be valuable. Since future profits are uncertain in a downturn, they are typically deducted.

When you look at a bank, treat the CET1 ratio as its primary health score.

• High and Stable is Beautiful: Look for banks that consistently maintain high CET1 ratios, well above the regulatory minimums. This indicates a conservative management team that prioritizes stability over short-term profits.
• Context is King: Always compare a bank's CET1 ratio to its direct peers. A regional bank might have different capital needs than a global investment banking giant.
• Check the Denominator: A bank can juice its CET1 ratio by either increasing its capital (good) or by shedding its Risk-Weighted Assets (could be good or bad). If a bank is shrinking its RWA, make sure it’s not just avoiding profitable lending opportunities. The best banks generate strong profits while maintaining a fortress-like capital position.