CET1 Ratio and Capital Requirements for Financial Institutions

DEVLHON Consulting explains: CET1 Ratio and Capital Requirements for Financial Institutions

The Common Equity Tier 1 (CET1) ratio is a key indicator of the financial strength of banking and financial institutions. It represents the highest quality capital, mainly composed of common stock and retained earnings, after deducting intangible assets and risk-weighted assets.

 Composition of Capital

The overall capital of financial institutions consists of three main categories:

Common Equity Tier 1 (CET1): Common shares, undistributed earnings, after regulatory deductions.

Additional Tier 1 (AT1): Financial instruments with specific characteristics, such as convertible bonds.

Tier 2 Capital: Long-term subordinated debt instruments.

CET1 is the strongest and most liquid component of capital, essential for absorbing losses during a crisis.

 Regulatory Requirements on Solvency Ratios

According to Regulation (EU) No 575/2013 (CRR), financial institutions must meet the following minimum ratios:

CET1 Ratio: Must be at least 4.5% of risk-weighted assets (RWA), plus capital buffers.

Tier 1 Ratio: Must be at least 6% of RWA, plus capital buffers.

Overall Solvency Ratio: Must be at least 8% of RWA, plus capital buffers.

 Additional Capital Buffers

Beyond the minimum ratios, financial institutions must maintain capital buffers:

Capital Conservation Buffer: 2.5% of RWA, serving as a reserve to absorb losses during financial stress.

Countercyclical Buffer: A variable rate set by the High Council for Financial Stability (HCSF), currently at 0% since April 1, 2020, due to the health crisis. This buffer aims to strengthen requirements during periods of excessive credit growth.

 Concept of Exemptions (Thresholds)

The “exemption” in terms of capital refers to thresholds or exemptions granted under certain conditions. For financial institutions:

Exemptions: Certain institutions may be exempt from applying capital requirements if they are subsidiaries of a banking group, in line with Article 7 of the CRR regulation.

Adaptation of Requirements: The Prudential Supervision and Resolution Authority (ACPR) may, on a case-by-case basis, require a financial institution to hold capital above the regulatory minimum, based on its risk profile.

 Importance of the CET1 Ratio

The CET1 ratio is crucial for:

Ensuring Financial Resilience: It ensures that the institution has sufficient high-quality capital to absorb unexpected losses.

Investor and Depositor Confidence: A high ratio strengthens confidence in the institution’s stability.

Regulatory Compliance: Failure to meet CET1 requirements can result in regulatory sanctions and limit the institution’s ability to pay dividends.

 Conclusion

The CET1 ratio and associated capital requirements are essential for the stability of the financial system. Financial institutions must not only meet the regulatory minimum ratios but also consider additional buffers and possible extra requirements imposed by the ACPR. Understanding and effectively managing these prudential obligations are crucial for ensuring the sustainability and resilience of financial institutions