FRM Exam Part II · Capital Structure in Banks

Regulatory Capital: CET1, AT1 and Tier 2 Explained

Updated 11 October 2026

Basel III regulatory capital is Tier 1 plus Tier 2. Tier 1 is Common Equity Tier 1 (CET1) plus Additional Tier 1 (AT1). CET1 is mainly common shares and retained earnings, less regulatory deductions. AT1 absorbs losses on a going concern. Tier 2 absorbs losses on a gone concern. To solve questions, classify each item, apply deductions to CET1, then compute ratios.

Understand Regulatory Capital: Tier 1 and Tier 2

Regulatory capital is the loss-absorbing funding that supervisors accept when they test a bank's solvency. Basel III splits it by quality. The better the capital absorbs losses while the bank is still operating, the higher the tier.

Common Equity Tier 1 (CET1) is the best quality. It includes common shares, share premium, retained earnings and accumulated other comprehensive income, plus certain qualifying minority interests. It has no maturity, no fixed payout and is fully available to absorb losses first.

Additional Tier 1 (AT1) is perpetual, subordinated and has fully discretionary coupons. It must have no step-ups or incentives to redeem. It must convert to equity or be written down when a pre-set trigger is hit. The trigger must be set at a CET1 ratio of at least 5.125% of RWA. This lets it absorb losses on a going concern basis. Tier 1 = CET1 + AT1.

Tier 2 is gone-concern capital. It absorbs losses in resolution or liquidation. Instruments are subordinated and have an original maturity of at least five years. In the final five years, recognition is amortised on a straight-line basis. Tier 2 also contains certain general provisions, subject to limits. Under Basel III, Tier 3 no longer exists.

Then come regulatory deductions. Goodwill and other intangibles, deferred tax assets that rely on future profitability and do not arise from temporary differences (such as tax loss carry-forwards), shortfall of provisions to expected losses under IRB, defined benefit pension fund assets, own shares (treasury stock) and securitisation gains on sale are deducted from CET1. Non-significant investments in the capital of unconsolidated financial institutions are deducted only for the aggregate amount above 10% of CET1. Significant investments in the common shares of unconsolidated financial institutions are not deducted in full. They are deducted only above the 10% threshold of CET1. The same 10% threshold applies individually to deferred tax assets from temporary differences and mortgage servicing rights. After those individual thresholds, the three items together are capped at 15% of CET1. Amounts that stay below the thresholds are not deducted, but they are risk-weighted at 250%. Deductions come off CET1 so they cut the highest quality capital first.

Minimum ratios are applied to risk-weighted assets (RWA): CET1 4.5%, Tier 1 6%, total capital 8%. Buffers sit on top, such as the 2.5% capital conservation buffer, all met with CET1.

Key formulas to remember

Tier 1 capital: Tier 1 = CET1 + AT1; Use CET1 after deductions. AT1 must meet all Basel criteria.
Total regulatory capital: Total capital = Tier 1 + Tier 2; Tier 3 was eliminated in Basel III.
Minimum CET1 ratio: CET1 ÷ RWA ≥ 4.5%; Before buffers. With the 2.5% conservation buffer, the effective level is 7%.
Minimum Tier 1 ratio: (CET1 + AT1) ÷ RWA ≥ 6%; CET1 must be at least 4.5% of RWA. AT1 can fill the remaining 1.5% needed to reach 6%.
Minimum total capital ratio: (Tier 1 + Tier 2) ÷ RWA ≥ 8%; With the 2.5% conservation buffer the effective level is 10.5%. The effective Tier 1 level is 8.5% and the effective CET1 level is 7%.
Tier 2 amortisation: Recognised amount = nominal × (years remaining ÷ 5), for the final 5 years; Straight-line; applies once residual maturity is under five years.
CET1 after deductions: CET1 = Common equity items − regulatory deductions; Goodwill and intangibles are deducted from CET1. Investments in capital instruments are deducted from the corresponding tier (AT1 from AT1, Tier 2 from Tier 2).

How to solve Regulatory Capital: Tier 1 and Tier 2 questions

Use this order for any classification or ratio question on regulatory capital.

1List every item given and note its features: perpetual or dated, coupon discretionary or fixed, loss absorption trigger, seniority.
2Assign each item to CET1, AT1 or Tier 2. Common equity and retained earnings go to CET1. Perpetual discretionary-coupon instruments with a trigger go to AT1. Dated subordinated debt goes to Tier 2.
3Identify deductions: goodwill, intangibles, reliant deferred tax assets, treasury stock, IRB provision shortfall, pension surplus assets. Subtract them from CET1.
4Adjust Tier 2 for amortisation if residual maturity is under five years.
5Compute CET1, Tier 1 and total capital.
6Divide each by RWA and compare with 4.5%, 6% and 8%, plus any buffer the question mentions.
7State the conclusion: compliant or shortfall, and which tier must be topped up. Check that the units match.

Quickest way: Three-bucket sort

When to use it: Use for classification questions or when time is short and options differ on tier or deduction treatment.

Ask: can the bank skip payment with no default and does the item never mature? If it has to be common equity, it is CET1.
If it is perpetual, subordinated, with discretionary coupons and a trigger, it is AT1. If it is dated and subordinated, it is Tier 2.
Any intangible, goodwill or treasury share is a deduction from CET1. Do this before any ratio.
Eliminate options that put deductions against Tier 2 or count Tier 3.

Common mistakes in Regulatory Capital: Tier 1 and Tier 2

Deducting goodwill from total capital or Tier 2 instead of CET1.
Students remember that goodwill is deducted but not where it comes off.
Fix: Goodwill and intangibles are deducted at the CET1 level first. Investments in capital instruments are deducted from the corresponding tier. Tier 1 and total capital then fall automatically.
Treating AT1 as debt that must pay coupons.
AT1 looks like a bond in the term sheet.
Fix: AT1 coupons must be fully discretionary and non-cumulative. Missing one is not a default.
Counting full Tier 2 value in the last years before maturity.
Students overlook amortisation.
Fix: In the last five years, apply straight-line amortisation. With 2 years left, only 2 ÷ 5 = 40% counts.
Saying Tier 1 minimum is 4.5%.
Confusing the CET1 minimum with the Tier 1 minimum.
Fix: Memorise 4.5% / 6% / 8% as CET1 / Tier 1 / Total, all on RWA.
Using Tier 2 or AT1 to meet the conservation buffer.
Buffers are seen as general capital.
Fix: The conservation buffer must be met with CET1.
Calling Tier 2 a going-concern buffer.
Both AT1 and Tier 2 are called loss-absorbing.
Fix: AT1 absorbs on a going concern via trigger conversion or write-down. Tier 2 absorbs on a gone concern.

Worked examples

Example 1

A bank reports: common shares and retained earnings USD 60 billion; goodwill and intangibles USD 6 billion; perpetual AT1 notes with discretionary coupons USD 8 billion; subordinated 10-year notes with 10 years left USD 12 billion. RWA is USD 800 billion. Compute CET1, Tier 1 and total capital ratios.

Show the solution

CET1 = 60 − 6 = USD 54 billion.
Tier 1 = 54 + 8 = USD 62 billion.
Tier 2 = USD 12 billion, no amortisation since residual maturity is over five years.
Total capital = 62 + 12 = USD 74 billion.
CET1 ratio = 54 ÷ 800 = 6.75%.
Tier 1 ratio = 62 ÷ 800 = 7.75%.
Total ratio = 74 ÷ 800 = 9.25%.

Answer: CET1 6.75%, Tier 1 7.75%, total capital 9.25%. All three exceed the 4.5%, 6% and 8% minima. If the 2.5% conservation buffer is applied, all three fall short of the buffered levels: CET1 6.75% is below 7%, Tier 1 7.75% is below 8.5%, and total capital 9.25% is below 10.5%.

Example 2

A bank has CET1 of EUR 30 billion, AT1 of EUR 5 billion and Tier 2 of EUR 10 billion, including a EUR 4 billion subordinated note with 3 years left. RWA is EUR 450 billion. What is the total capital ratio after applying amortisation?

Show the solution

Amortised value of the note = 4 × (3 ÷ 5) = EUR 2.4 billion.
Reduction = 4 − 2.4 = EUR 1.6 billion.
Adjusted Tier 2 = 10 − 1.6 = EUR 8.4 billion.
Tier 1 = 30 + 5 = EUR 35 billion.
Total capital = 35 + 8.4 = EUR 43.4 billion.
Total ratio = 43.4 ÷ 450 = 9.644%.

Answer: The total capital ratio is about 9.64%.

Exam tips

Questions often hide the answer in instrument features. Look for perpetual, discretionary coupon, trigger and maturity.
Apply deductions to CET1 before any ratio. Options that skip this are usually wrong.
Check whether the question asks for ratio or surplus over a minimum. Compute the amount as capital minus ratio × RWA.
Remember that buffers must be met with CET1 and are above the 4.5% minimum.
In the last five years, amortise Tier 2 by remaining years ÷ 5.

Practice questions from Capital Structure in Banks

Regulatory Capital: Tier 1 and Tier 2: frequently asked questions

What is the difference between Tier 1 and Tier 2 capital?

Tier 1 absorbs losses while the bank is still operating (going concern). It includes CET1 and AT1. Tier 2 absorbs losses only when the bank fails or is resolved (gone concern), mainly via dated subordinated debt.

What is the difference between CET1 and AT1?

CET1 is common equity: shares and retained earnings, less deductions. AT1 is a perpetual subordinated instrument with discretionary coupons and a conversion or write-down trigger. CET1 is the highest quality capital.

What are the main regulatory deductions in Basel III?

Goodwill and intangibles, deferred tax assets that rely on future profit, treasury shares, IRB provision shortfalls and defined benefit pension assets come off CET1. Investments in own or other institutions' AT1 and Tier 2 instruments are deducted from the corresponding tier. Significant investments in financial institutions get threshold treatment.

What are the Basel III minimum capital ratios?

CET1 4.5%, Tier 1 6% and total capital 8% of risk-weighted assets. The capital conservation buffer adds 2.5%, met with CET1.