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Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It is composed of core capital,[1] which consists primarily of common stock and disclosed reserves (or retained earnings)[2], but may also include irredeemable non-cumulative preferred stock.

Capital in this sense is related to, but different from, the accounting concept of shareholder's equity. Both tier 1 and tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord.

Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework varies in different legal systems.

The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses which are covered by provisions, reserves and current year profits.

The Tier 1 capital ratio is the ratio of a bank's core equity capital to its total risk-weighted assets. Risk-weighted assets are the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country's Central Bank). Most central banks follow the Bank of International Settlements (BIS) guidelines in setting formulae for asset risk weights. Assets like cash and coins usually have zero risk weight, while debentures might have a risk weight of 100%.

A good definition of Tier I capital is that it includes equity capital and disclosed reserves, where equity capital includes instruments that can't be redeemed at the option of the holder (meaning that the owner of the shares cannot decide on his own that he wants to withdraw the money he invested and so cannot leave the bank without the risk coverage). Reserves are held by the bank, and are thus money that no one but the bank can have an influence on.

Tier 1 capital is also seen as a metric of a bank's ability to sustain future losses. In October 2008,[3] a number of British banks have seen an erosion of their market capitalization due of their lower Tier 1 capital. In order to boost the Tier 1 capital of these banks and restore confidence in the banking system, the UK Treasury has decided to part-nationalise the UK banks. The plan will allow seven banks, Abbey, Barclays, HBOS, HSBC, Lloyds TSB, Royal Bank of Scotland and Standard Chartered, as well as the Nationwide Building Society, to apply for an initial amount of £25bn in permanent capital. The Treasury may possibly impose conditions on executive compensation and dividend cuts from the banks. This capital is expected to come in the form of preference shares or other permanent interest-bearing shares...