Common Equity Tier 1 (CET1) Capital

Common Equity Tier 1 (CET1) Capital is the highest quality form of regulatory capital in the modern banking system. It represents the core financial strength of a bank, designed to absorb losses on a going-concern basis and protect depositors as well as the wider financial system. In the context of banking and finance, CET1 has gained particular importance after the global financial crisis of 2008, and it plays a crucial role in ensuring the stability and resilience of the Indian banking sector and the Indian economy as a whole.

Concept and Definition of CET1 Capital

CET1 Capital refers to the most reliable and loss-absorbing component of a bank’s capital base. It primarily consists of ordinary equity and retained earnings, which are permanently available to support a bank’s operations. Unlike other forms of capital, CET1 does not impose mandatory repayment obligations on the bank, making it especially effective during periods of financial stress.
Under international banking regulations, CET1 is distinguished from Additional Tier 1 (AT1) and Tier 2 capital on the basis of its quality and permanence. CET1 capital is the first line of defence against losses and forms the foundation of the capital adequacy framework in modern banking.

Components of CET1 Capital

The main components of CET1 Capital include:

• Paid-up equity share capital, representing ordinary shares issued by the bank.
• Statutory reserves, such as those created under banking laws.
• Disclosed free reserves, including retained earnings and accumulated profits.
• Other comprehensive income, subject to regulatory adjustments.

From these elements, certain deductions are made to arrive at net CET1 capital. These deductions typically include goodwill, deferred tax assets dependent on future profitability, and investments in financial subsidiaries. Such adjustments ensure that CET1 reflects only truly loss-absorbing capital.

Regulatory Framework and Basel III Norms

The global standard for CET1 capital has been shaped by the Basel III framework introduced by the Basel Committee on Banking Supervision. Basel III significantly strengthened capital requirements following the weaknesses exposed during the global financial crisis.
Under Basel III, banks are required to maintain a minimum CET1 ratio of 4.5 per cent of risk-weighted assets (RWAs), in addition to a Capital Conservation Buffer. These norms aim to enhance the resilience of banks by ensuring that they hold sufficient high-quality capital during normal times, which can be drawn down during periods of stress.
In India, Basel III norms have been implemented in a phased manner under the supervision of the Reserve Bank of India. Indian banks are generally required to maintain CET1 ratios higher than the global minimum, reflecting the conservative regulatory approach adopted to safeguard financial stability.

CET1 Capital and the Capital Adequacy Ratio

CET1 Capital is a critical component of the Capital Adequacy Ratio (CAR), which measures a bank’s capital relative to its risk-weighted assets. The CET1 ratio is calculated as:
CET1 Capital ÷ Risk-Weighted Assets
A higher CET1 ratio indicates a stronger capital position and a greater ability to withstand financial shocks. Risk-weighted assets take into account the credit risk, market risk, and operational risk associated with a bank’s exposures, ensuring that capital requirements are aligned with underlying risks.

Importance of CET1 Capital in Banking and Finance

CET1 Capital is central to the sound functioning of banks and financial systems. Its importance can be understood through several key dimensions:

• Loss absorption: CET1 absorbs losses before any other form of capital, reducing the probability of bank failure.
• Confidence building: Strong CET1 levels enhance depositor and investor confidence in the banking system.
• Systemic stability: Adequate CET1 buffers limit contagion effects during financial crises.
• Regulatory discipline: CET1 requirements discourage excessive leverage and risky lending practices.

In financial markets, CET1 ratios are closely monitored by regulators, rating agencies, and investors as an indicator of a bank’s financial health.

CET1 Capital in the Indian Banking System

In India, CET1 Capital has assumed particular significance due to structural challenges in the banking sector, especially among public sector banks. Issues such as non-performing assets (NPAs), credit concentration, and economic slowdowns have directly impacted banks’ capital positions.
The Reserve Bank of India mandates Indian banks to maintain a CET1 ratio higher than the Basel III minimum, along with additional buffers. This has led to periodic capital infusion by the Government of India into public sector banks to strengthen their CET1 base. Private sector banks, on the other hand, have often raised CET1 capital through equity markets.
The focus on CET1 has contributed to improved balance sheet resilience and better risk management practices across the Indian banking system.

Role of CET1 Capital in the Indian Economy

CET1 Capital plays a vital role in supporting the broader Indian economy. Well-capitalised banks are better positioned to extend credit to productive sectors such as infrastructure, manufacturing, agriculture, and small and medium enterprises. Strong CET1 buffers ensure continuity of lending even during economic downturns, thereby supporting growth and employment.
During periods of economic stress, such as global financial disruptions or domestic slowdowns, adequate CET1 capital helps Indian banks absorb losses without sharply curtailing credit supply. This stabilising role is essential for maintaining macroeconomic stability and sustaining long-term economic development.

Challenges and Criticisms

Despite its importance, CET1 Capital requirements are not without challenges. Higher CET1 thresholds can increase the cost of capital for banks, potentially affecting profitability. For public sector banks in India, meeting CET1 norms often depends on government capital support, raising concerns about fiscal burden.
There is also criticism that excessive capital requirements may constrain credit growth, particularly in developing economies. However, regulators generally view these costs as acceptable in exchange for greater financial stability and reduced systemic risk.