Core Capital: What it is, How it Works, Example

What Is Core Capital?

Core capital refers to the minimum amount of capital that a thrift bank, such as a savings bank or a savings and loan company, must have on hand in order to comply with Federal Home Loan Bank (FHLB) regulations. This measure was developed as a safeguard with which to protect consumers against unexpected losses.

The Federal Home Loan Bank regulations require banks to have core capital that represents a minimum of 6% of the bank's risk-weighted overall assets, which may entail equity capital (common stock) and declared reserves (retained assets). Created to ensure that consumers are protected when creating financial accounts, core capital comprises a substantial portion of Tier 1 capital, which regulators view as a measure of a bank's financial strength.

Tier 1 capital refers to the ratio of a bank's core equity capital to the entire amount of risk-weighted assets (total assets, weighted by credit risk) that a bank owns. The risk-weighted assets are defined by The Basel Committee on Banking Supervision, a banking supervisory authority created by the central bank governors from more than a dozen nations.

Banks are deemed less susceptible to failure if they have more core capital and fewer risk-weighted assets. On the other hand, regulators consider banks prone to failure, if the opposite is true.

Tier 1 Example

To better understand how Tier 1 ratios work, consider the following scenario. Let us assume that the Friendly Bank, which holds $3 of equity assets, lends $20 to a customer. Assuming that this loan, which is now itemized as a $20 asset on the bank's balance sheet, has a risk weighting of 80%. In this case, the Friendly Bank carries $16 worth of risk-weighted assets ($20 × 80%). Considering its original $3 equity, the Friendly Bank's Tier 1 ratio is calculated to be $3/$16 or 19%.

According to the latest figures, the Tier 1 Capital ratio has been set at 6%. Therefore, the Friendly Bank would presently be compliant with current banking authority regulations.

Understanding Core Capital

Following the financial crisis of 2008, regulators began increasing their focus on banks' Tier 1 capital, which not only consists of core capital but may also include non-redeemable, noncumulative preferred equity. This is more stringent than typical capital ratios, which can also include Tier 2 and lesser-quality capital. Financial institutions are expected to adhere to the Tier 1 capital ratios defined in Basel III regulations, which were issued to improve banking regulation and supervision while mitigating the possibility of a future financial crisis.

The increase in capital ratio requirements was established primarily due to the fact that capital depletion occurred in large quantities at major U.S. financial institutions. According to studies, twelve institutions had capital ratio erosion in excess of 300 basis points, and eight such institutions had capital ratio erosion in excess of 450 basis points.

To ensure that their capital requirements adhere to Basel III requirements, banks have undertaken a number of measures, including shedding their non-performing and risky assets and pruning employee headcounts. Furthermore, some financial institutions have also merged with well-capitalized entities in a strategic effort to boost their capital. Such mergers result in a reduction of risk-weighted assets and increased availability of core capital to both bank parties involved.