Common Equity Tier 1 (CET1) Ratio

The Common Equity Tier 1 (CET1) Ratio is a key measure of a bank’s core financial strength and resilience. It assesses the proportion of the highest quality capital held by a bank relative to its risk-weighted assets and indicates the institution’s capacity to absorb losses without disrupting normal operations. In modern banking and finance, the CET1 Ratio occupies a central position in prudential regulation and is particularly significant for the stability and growth of the Indian banking system and the wider Indian economy.

Meaning and Concept of the CET1 Ratio

The CET1 Ratio represents the relationship between a bank’s Common Equity Tier 1 capital and its risk-weighted assets (RWAs). CET1 capital consists of the most permanent and reliable forms of capital, primarily ordinary equity and retained earnings, which are fully available to absorb losses on a going-concern basis.
The ratio is expressed as a percentage and is calculated by dividing CET1 capital by total risk-weighted assets. A higher CET1 Ratio signifies a stronger capital base and greater financial resilience, while a lower ratio indicates vulnerability to financial stress. Regulators, investors, and analysts consider this ratio one of the most important indicators of a bank’s soundness.

Components of the CET1 Ratio

The CET1 Ratio is based on two fundamental elements: CET1 capital and risk-weighted assets. CET1 capital includes paid-up equity share capital, statutory reserves, disclosed free reserves, and retained earnings. From these components, regulatory deductions are made, such as goodwill, deferred tax assets dependent on future profitability, and certain investments in subsidiaries or financial institutions.
Risk-weighted assets reflect the total assets of a bank adjusted for different types of risk, including credit risk, market risk, and operational risk. Assets with higher risk attract higher risk weights, thereby requiring more capital support. This ensures that the CET1 Ratio captures not just the size of a bank but also the risk profile of its activities.

Basel III Framework and Global Standards

The CET1 Ratio gained prominence under the Basel III regulatory framework, which was introduced in response to the global financial crisis of 2008. Basel III aimed to strengthen the quality and quantity of bank capital, with a particular emphasis on common equity.
Under Basel III, banks are required to maintain a minimum CET1 Ratio of 4.5 per cent of risk-weighted assets, in addition to a Capital Conservation Buffer. These requirements are designed to ensure that banks accumulate adequate capital during normal economic periods, which can then be used to absorb losses during times of financial stress without threatening solvency.

CET1 Ratio within the Capital Adequacy Framework

The CET1 Ratio forms a crucial component of the overall Capital Adequacy Ratio (CAR), which measures a bank’s total capital relative to its risk-weighted assets. While CAR includes Tier 1 and Tier 2 capital, the CET1 Ratio focuses exclusively on the highest-quality capital.
Regulators and financial markets often attach greater importance to the CET1 Ratio than to overall CAR because weaker forms of capital may not be fully effective in absorbing losses. As a result, CET1 is widely regarded as the most stringent and informative measure of bank capital adequacy.

CET1 Ratio in the Indian Banking System

In India, the CET1 Ratio holds particular importance due to the dominance of banks in financial intermediation and the presence of structural challenges such as non-performing assets. The implementation of Basel III norms in India has been overseen by the Reserve Bank of India, which has adopted a conservative approach to capital regulation.
Indian banks are required to maintain CET1 Ratios above the global minimum, along with additional regulatory buffers. Public sector banks, which account for a significant share of banking assets, have often faced pressure on their CET1 Ratios due to high provisioning requirements. To address this, the Government of India has periodically infused capital to strengthen their equity base. Private sector banks have generally relied on equity markets and retained earnings to maintain strong CET1 positions.

Role of the CET1 Ratio in Financial Stability

The CET1 Ratio plays a vital role in maintaining financial stability. A strong CET1 Ratio enhances a bank’s ability to absorb unexpected losses while continuing to lend and meet its obligations. This reduces the probability of bank failures and limits the risk of contagion within the financial system.
From a macroeconomic perspective, banks with robust CET1 Ratios are less likely to reduce lending sharply during economic downturns. This stabilising function helps protect the real economy from financial shocks and supports smoother economic cycles.

CET1 Ratio and Credit Growth in India

The CET1 Ratio has a direct bearing on a bank’s capacity to extend credit. Since higher-risk assets require greater capital backing, banks with weaker CET1 Ratios may face constraints on lending. In India, periods of balance sheet stress have highlighted this relationship, as banks focused on strengthening capital positions rather than expanding credit.
At the same time, higher CET1 Ratios improve market confidence and reduce funding costs. Over the long term, this supports sustainable credit growth, financial inclusion, and efficient allocation of resources across sectors such as infrastructure, manufacturing, agriculture, and small enterprises.

Challenges and Criticisms

Despite its significance, the CET1 Ratio is associated with certain challenges. Maintaining high CET1 levels can raise the cost of capital and affect bank profitability. In the Indian context, repeated capital infusions into public sector banks have raised concerns regarding fiscal pressure and efficient capital utilisation.
There is also criticism that stringent CET1 requirements may constrain credit growth in developing economies. However, regulators generally regard these costs as acceptable when weighed against the benefits of reduced systemic risk and enhanced financial stability.