The own funds of an institution consist of the sum of its tier 1 capital and tier 2 capital. Tier 1 capital comprises common equity tier 1 capital and additional tier 1 capital.
The Capital Requirements Regulation (CRR) stipulates, inter alia, what can be recognised as capital in prudential terms. It also contains regulations for reducing own funds as well as items which are to be deducted from capital.
Common equity tier 1 capital (Articles 26-50 CRR )
Supervisors focus particularly on institutions’ common equity tier 1 capital (CET 1). It consists of paid-in capital instruments which have to fulfil certain requirements, and disclosed reserves. Both components must be available to institutions for unrestricted and immediate use to cover risks or losses. Institutions must have a common equity tier 1 capital ratio of at least 4.5%. Capital buffer requirements also have to be met using CET 1 capital.
Additional tier 1 capital (Articles 51-61 CRR)
Like common equity tier 1 capital, additional tier 1 capital (AT 1) should be continuously available for loss absorbency purposes, thereby enabling the bank to continue on a going-concern basis. Some of the key requirements that instruments in this capital class must meet are that they be subordinated, that they be perpetual, and that distributions be fully discretionary. Moreover, for additional tier 1 capital, institutions must ensure that it is possible for the instruments to be converted into common equity tier 1 capital or to be written down, at the latest once the common equity tier 1 capital ratio falls below a threshold of 5.125%. The sum of common equity tier 1 capital and additional tier 1 capital is called tier 1 capital. Institutions must have a tier 1 capital ratio of at least 6.0%.
Tier 2 capital (Articles 62-71 CRR)
The function of tier 2 capital is to provide creditor protection in the event of insolvency. Tier 2 capital instruments must have an original maturity of at least five years and must be subordinated with respect to repayment if the institution becomes insolvent. The sum of common equity tier 1 capital, additional tier 1 capital and tier 2 capital is called total capital. Institutions must have a total capital ratio of at least 8.0%.