CET1, AT1, Tier 1 and Tier 2 Capital Components - Article

Introduction

Capital is the financial cushion that protects a bank when losses arise.

However, every item called “capital” in accounting does not automatically qualify as regulatory capital.

Basel III gives greater importance to capital that can genuinely absorb losses. Regulatory capital is therefore arranged in a hierarchy based mainly on:

• permanence;

• subordination;

• ability to absorb losses;

• flexibility of distributions; and

• availability when the bank is under financial stress.

The current IIBF CAIIB BFM Module B covers Basel III, capital charges, buffers and related risk regulation. The 2026 syllabus also advises candidates to keep themselves updated with current RBI and Basel developments because regulatory changes can be examined.

The basic structure is:

Tier 1 Capital = CET1 + AT1Total Regulatory Capital = Tier 1 + Tier 2

The current Basel Framework classifies regulatory capital into:

1. Common Equity Tier 1 – CET1

2. Additional Tier 1 – AT1

3. Tier 2 Capital

CET1 and AT1 are classified as going-concern capital, while Tier 2 primarily provides gone-concern loss absorption.

Learning Objectives

After studying this topic, you should be able to:

• explain CET1, AT1, Tier 1 and Tier 2 capital;

• identify their major components;

• distinguish going-concern from gone-concern capital;

• understand the hierarchy of loss absorption;

• compare Basel minimum capital ratios with RBI requirements in India; and

• avoid common CAIIB traps involving AT1 and Tier 2 instruments.

Why Capital Quality Matters

Suppose a bank suffers heavy losses.

Capital is useful only if it can actually absorb those losses without immediately forcing the bank to default on ordinary creditors.

Therefore, Basel III focuses not only on:

How much capital does the bank have?

but also on:

What is the quality of that capital?

Common equity is considered the strongest form because it is:

• permanent;

• fully subordinated;

• exposed to losses;

• not contractually repayable like normal debt; and

• available to absorb losses while the bank continues operations.

Basel therefore requires the predominant form of Tier 1 capital to consist of common shares and retained earnings.

Common Equity Tier 1 – CET1

Common Equity Tier 1 is the highest-quality regulatory capital.

Basel identifies principal CET1 elements such as:

• qualifying common shares;

• related share premium;

• retained earnings;

• accumulated other comprehensive income and disclosed reserves;

• eligible minority interests of consolidated subsidiaries; and

• applicable regulatory adjustments.

For an Indian bank, the exact eligible elements and deductions are governed by RBI’s Basel III Capital Regulations.

RBI’s current published Master Circular on Basel III Capital Regulations is dated 1 April 2025 and applies to scheduled commercial banks covered by that circular, excluding Small Finance Banks, Payments Banks and Regional Rural Banks.

Major CET1 Components for an Indian Bank

Important components broadly include eligible:

• paid-up equity share capital;

• share premium relating to eligible common equity;

• statutory reserves;

• disclosed free reserves;

• capital reserves meeting regulatory conditions;

• retained earnings or eligible profit balances; and

• qualifying minority interest at consolidated level.

These amounts are taken after applicable regulatory adjustments and deductions.

Regulatory Adjustments

Certain accounting assets cannot be treated as fully loss-absorbing bank capital.

Accordingly, Basel/RBI rules require specified adjustments involving items such as:

• goodwill;

• specified intangible assets;

• certain deferred tax assets;

• specified investments in financial-sector entities; and

• other items prescribed under the regulatory framework.

Therefore:

Accounting equity and regulatory CET1 are not necessarily the same amount.

Why CET1 Is Strongest

Qualifying common equity represents the most subordinated claim.

Basel requires qualifying common shares to absorb losses and remain permanent capital rather than creating a fixed repayment claim on the bank.

Example

If a bank suffers a large loss:

• retained earnings may fall;

• reserves may reduce; and

• shareholders bear the economic loss.

There is no contractual requirement to repay ordinary shareholders simply because the bank has made losses.

This makes CET1 particularly effective as a going-concern loss absorber.

Additional Tier 1 – AT1

Additional Tier 1 Capital is also Tier 1 capital, but it is not Common Equity.

Basel describes AT1 as qualifying instruments and related eligible amounts that satisfy strict regulatory criteria.

AT1 provides additional loss-absorbing capacity while the bank remains a going concern.

Important Characteristics of AT1

A qualifying AT1 instrument should broadly be:

• issued and fully paid;

• subordinated to depositors and senior creditors;

• unsecured;

• perpetual;

• without a normal maturity date;

• free from incentives that effectively force redemption;

• capable of having distributions cancelled; and

• capable of absorbing principal losses under required conditions.

Basel specifically requires AT1 instruments to be perpetual.

AT1 Instruments in India

Under RBI’s Basel III framework, important AT1 instruments for Indian banks include qualifying:

• Perpetual Non-Cumulative Preference Shares – PNCPS

• Perpetual Debt Instruments – PDI

subject to detailed RBI eligibility conditions.

Why “Perpetual” Matters

Normal debt has a maturity date when principal becomes repayable.

AT1 generally does not.

This makes it more suitable as permanent loss-absorbing capital.

Coupon or Dividend on AT1

AT1 is very different from an ordinary bank deposit or conventional bond.

The bank must have sufficient discretion over distributions.

For qualifying AT1 debt instruments, RBI requires banks to retain the ability to cancel coupon payments in accordance with the applicable regulatory conditions. Non-payment does not operate like normal default on ordinary debt.

This feature supports loss absorption during stress.

AT1 Loss Absorption

This is one of the most important CAIIB concepts.

AT1 cannot qualify merely because it is called “perpetual debt”.

It must contain appropriate loss-absorption features.

Under the RBI framework, qualifying AT1 instruments may have principal loss absorption through:

• conversion into common equity; or

• write-down,

when the prescribed trigger is reached.

The RBI framework specifies an AT1 pre-specified CET1 trigger of at least 6.125% of RWA for the relevant instruments and also provides for loss absorption at the Point of Non-Viability (PONV).

Meaning of Write-Down

A write-down may reduce:

• the investor’s principal claim;

• repayment amount; and

• future coupon entitlement,

depending on the applicable instrument terms.

Therefore, AT1 investors can suffer significant loss before ordinary depositors or senior creditors.

What Is Tier 1 Capital?

Tier 1 should not be confused with CET1.

The Basel relationship is:

Tier 1 Capital = CET1 + AT1

Therefore:

• CET1 is a component of Tier 1;

• AT1 is another component of Tier 1; and

• Tier 1 is broader than CET1.

Simple Example

If a bank has:

• eligible CET1; and

• eligible AT1 instruments,

both together form its Tier 1 regulatory capital, after applicable adjustments.

Tier 2 Capital

Tier 2 Capital is lower in the regulatory capital hierarchy than Tier 1.

Its main regulatory objective is to provide loss absorption on a gone-concern basis.

This means it is principally intended to absorb losses when a bank has reached or is approaching non-viability rather than serving as the primary capital supporting ordinary continuing operations.

Basel states this objective explicitly.

Major Tier 2 Elements

Under the Basel framework, Tier 2 can include:

• qualifying subordinated capital instruments;

• related eligible share premium;

• eligible subsidiary-issued instruments;

• certain eligible loan-loss provisions; and

• applicable regulatory adjustments.

Under RBI’s Indian framework, eligible Tier 2 may include qualifying:

• debt capital instruments;

• prescribed preference-share instruments;

• general provisions and loss reserves within regulatory limits; and

• other specifically eligible items.

The exact eligibility conditions must be satisfied before any instrument can be counted as regulatory capital.

Tier 2 Debt Characteristics

Basel requires qualifying Tier 2 instruments to be:

• paid in;

• subordinated to depositors and general creditors;

• unsecured; and

• issued with a minimum original maturity of at least five years.

Unlike AT1:

Tier 2 may have a maturity date.

This is a major exam distinction.

RBI also permits qualifying Tier 2 debt and specified Tier 2 preference-share instruments with a minimum original maturity of at least five years, subject to regulatory conditions.

Going-Concern vs Gone-Concern Capital

Simple Meaning

Going concern: Bank is still operating.

Gone concern: Bank has reached severe distress/non-viability and capital is needed to absorb losses during resolution or failure.

RBI Minimum Capital Requirements in India

This is a major exam area because Basel global minimum ratios and RBI Indian ratios are different.

Basel Global Minimum

Under the Basel standard, banks must maintain at least:

• CET1: 4.5% of RWA

• Tier 1: 6% of RWA

• Total Capital: 8% of RWA

A CET1 Capital Conservation Buffer of 2.5% of RWA applies above the minimum, apart from other buffers where applicable.

RBI Requirement for Covered Scheduled Commercial Banks

Under the RBI framework, covered scheduled commercial banks maintain:

• Minimum CET1: 5.5% of RWA

• Minimum Tier 1: 7% of RWA

• Minimum Total Capital/CRAR: 9% of RWA

• Capital Conservation Buffer: 2.5% of RWA in CET1

Thus:

• CET1 plus CCB = 8%

• Total minimum capital plus CCB = 11.5%

These Indian regulatory ratios are reflected in RBI’s Basel III framework and continue to be applied under the current Master Circular dated 1 April 2025.

Basel vs RBI Capital Minima

Other buffers, such as those applicable to systemically important banks or a countercyclical buffer when activated, can increase the effective requirement further.

Is AT1 Capped at 1.5% and Tier 2 at 2%?

This is a common source of confusion.

The minimum RBI structure can be understood as:

• CET1 minimum = 5.5%

• Tier 1 minimum = 7%

Therefore, the difference is 1.5 percentage points.

Similarly:

• Tier 1 minimum = 7%

• Total minimum = 9%

The difference is 2 percentage points.

Older explanations sometimes convert this arithmetic into statements such as:

“AT1 cannot exceed 1.5%” “Tier 2 cannot exceed 2%”

as though these were absolute caps on all eligible capital.

That is misleading.

RBI withdrew earlier restrictions on recognition of excess AT1 and Tier 2 capital in 2014. Eligible capital above the minimum structure can therefore be recognised subject to the applicable regulatory conditions.

CAIIB Interpretation

The figures 1.5% and 2% explain the composition needed to bridge the minimum ratios:

5.5 CET1 + 1.5 = 7 Tier 1

7 Tier 1 + 2 = 9 Total Capital

They should not be memorised as universal absolute ceilings on all AT1 and Tier 2 capital.

Loss-Absorption Hierarchy

Suppose a bank suffers increasingly severe financial stress.

Conceptually:

First Layer – CET1

Common shareholders and retained earnings bear losses first.

Second Layer – AT1

AT1 can absorb losses through:

• cancellation of distributions;

• conversion; or

• write-down

under applicable conditions.

Third Layer – Tier 2

Tier 2 provides additional loss absorption, particularly when the institution approaches non-viability.

Depositors and Senior Creditors

Regulatory capital is designed to absorb losses before ordinary depositor and senior-creditor claims according to the legal and resolution framework.

This explains why capital instruments must be subordinated.

Practical Banking Application

Suppose a bank plans to strengthen its regulatory capital.

Management considers three choices:

Option 1 – Issue Ordinary Equity

This normally strengthens CET1, subject to eligibility and regulatory adjustments.

It provides the strongest regulatory capital.

Option 2 – Issue a Qualifying Perpetual Debt Instrument

If the instrument satisfies the prescribed conditions, including subordination, permanence and loss absorption, it may qualify as AT1.

It does not automatically qualify merely because the bank calls it a perpetual bond.

Option 3 – Issue Five-Year Subordinated Debt

If the instrument satisfies applicable Tier 2 criteria, it may qualify as Tier 2.

It cannot be treated as AT1 merely because it is subordinated, because AT1 normally requires perpetual capital.

Therefore, the classification depends on the terms and loss-absorption characteristics, not merely the instrument’s name.

CAIIB Exam Focus

Remember these high-value concepts:

• Regulatory capital consists of CET1, AT1 and Tier 2.

• Tier 1 = CET1 + AT1.

• Total Regulatory Capital = Tier 1 + Tier 2.

• CET1 is the highest-quality capital.

• CET1 primarily includes qualifying common equity, share premium, retained earnings and eligible reserves after regulatory adjustments.

• CET1 is going-concern capital.

• AT1 is also going-concern capital.

• AT1 instruments are perpetual.

• Indian AT1 instruments include qualifying PNCPS and PDI.

• AT1 distributions are subject to strong regulatory discretion and loss-absorption requirements.

• RBI’s AT1 framework includes conversion/write-down features and a pre-specified CET1 trigger of at least 6.125% for relevant instruments.

• Tier 2 primarily provides gone-concern loss absorption.

• Tier 2 instruments may be dated, with qualifying debt having at least five years’ original maturity.

• Basel global minima are CET1 4.5%, Tier 1 6% and Total Capital 8%.

• RBI minima for covered scheduled commercial banks are CET1 5.5%, Tier 1 7% and Total Capital 9%.

• RBI CCB is 2.5% of RWA in CET1.

• RBI minimum Total Capital plus CCB is therefore 11.5%.

• AT1 and Tier 2 eligibility depends on detailed regulatory criteria, not merely instrument labels.

Common Exam Traps

Trap 1: “CET1 and Tier 1 Are the Same”

Incorrect.

Tier 1 = CET1 + AT1.

Trap 2: “Tier 2 Is Part of Tier 1”

Incorrect.

Tier 2 is separate and is added to Tier 1 to arrive at Total Regulatory Capital.

Trap 3: “AT1 Has a Normal Maturity Date”

Incorrect.

Qualifying AT1 is generally perpetual.

Trap 4: “Tier 2 Must Also Be Perpetual”

Incorrect.

Qualifying Tier 2 debt may be dated and must generally have at least five years’ original maturity.

Trap 5: “AT1 Is Ordinary Senior Debt”

Incorrect.

AT1 is deeply subordinated and designed to absorb losses.

Trap 6: “Basel and RBI Minimum Capital Ratios Are Identical”

Incorrect.

Basel’s global minimums are 4.5%-6%-8%, while RBI prescribes 5.5%-7%-9% for the scheduled commercial banks covered by its framework.

Trap 7: “The CCB Can Be Maintained through Tier 2 Debt”

Incorrect.

The Capital Conservation Buffer is required in CET1.

Trap 8: “AT1 Is Absolutely Capped at 1.5% and Tier 2 at 2%”

Misleading.

Those figures explain the gaps within RBI’s minimum 5.5%-7%-9% structure. Earlier restrictions on recognition of excess AT1 and Tier 2 were withdrawn.

Memory Technique

Remember C-A-T:

• C – CET1: Core and strongest capital

• A – AT1: Additional perpetual going-concern capital

• T – Tier 2: Terminal/gone-concern loss absorption

And remember the hierarchy:

Tier 1 = CET1 + AT1Total Capital = CET1 + AT1 + Tier 2