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L.13 · BEGINNER · 3 MIN

Bank Capital, Tier 1 Ratios, and Stress Tests

Bank capital is the equity cushion that absorbs losses before depositors and bondholders take a hit. Regulators express it as a ratio: capital divided by risk-weighted assets. The higher the ratio, the more the bank can lose before it becomes insolvent. Stress tests are the regulators' way of asking 'how would your capital ratio hold up if everything went wrong at once?' — and investors should understand both what those tests measure and what they cannot.

Quiz · 5 questions ↓
§ 01
Capital tierWhat countsRegulatory minimum
CET1 (Common Equity Tier 1)Common stock + retained earnings4.5% of RWA, plus buffers (typically ~8-11% all-in)
Additional Tier 1Preferred stock, contingent convertiblesCounted in total Tier 1 (6% minimum)
Tier 2Subordinated debt, certain reservesCounted in total capital (8% minimum)
Risk-Weighted AssetsAssets adjusted for credit and market riskTreasuries weighted near zero; risky loans up to 150%
§ 02

CET1 is the ratio that matters most. It captures the highest-quality, most loss-absorbing form of capital — common equity. When a bank's CET1 ratio falls below the regulatory floor plus its specific buffer, dividends and buybacks get restricted automatically. When it falls further, the bank must shrink lending or raise new equity (dilutive to existing shareholders).

§ 03
Stress testWho runs itWhat it measures
CCARFederal Reserve, annualCapital adequacy under severely adverse macro scenarios for the largest US banks
DFASTFederal Reserve, annualSame supervisory scenarios as CCAR; broader bank population
Internal stress testsEach bank's risk teamTail-risk scenarios specific to the bank's portfolio and geography
§ 04

What stress tests miss: they model the scenarios regulators pick, with the assumptions regulators make. The 2023 regional-bank failures were triggered by deposit-velocity dynamics that no pre-2023 stress scenario captured. A clean stress-test result reduces — but does not eliminate — the probability of bank failure. Pair the ratio with a look at deposit composition, unrealized losses on held-to-maturity securities, and concentration of large depositors.

§ 05

When evaluating any bank, read three numbers together: (1) reported CET1 ratio, (2) the bank's stress-test minimum (the lowest CET1 it would reach under severe stress), and (3) its 'stress capital buffer' (the surcharge regulators add above the 4.5 percent floor). The gap between current CET1 and the stress-test minimum is the bank's actual loss-absorption headroom — that, not the headline ratio, is what tells you how much trouble the bank could ride out.

§ 06
Pull the latest stress-test results page from the Federal Reserve (federalreserve.gov, CCAR section). Pick three large banks and compare each bank's stressed CET1 minimum against its reported CET1. The wider the headroom above the regulatory floor, the more resilient the bank. Note which banks are tightest — they have less room for adverse surprises.
§ 07
A bank reports CET1 at 11 percent — well above the 4.5 percent regulatory floor — but the latest stress test shows its CET1 would fall to 6 percent under severely adverse conditions. What does the gap tell you about how the bank is positioned for a recession?
Five questions · AI feedback

Sit with the ideas.

A large US bank passes its annual CCAR stress test with a stressed CET1 minimum of 7.2 percent — comfortably above the 4.5 percent regulatory floor and the bank's stress capital buffer. Press coverage calls the result a 'clean pass.' What does that actually prove about the bank's safety?

Why:

Other lessons in this course.

  1. 01Inflation: What It Is and Why It Matters
  2. 02The Fed and Interest Rates: How Policy Moves Markets
  3. 03The Yield Curve, in Plain English
  4. 04GDP: What the Economy Actually Produces
  5. 05The Business Cycle: Timing the Economic Seasons
  6. 06Fiscal Policy: Government Spending, Taxes, and Deficits
  7. 07The Fed’s Advanced Toolkit: QE, QT, and Forward Guidance
  8. 08Trade, Exchange Rates, and the Dollar
  9. 09Financial Crises: How Economies Break Down
  10. 10How the Federal Reserve Actually Works
  11. 11How Banks Create Money (and Why Reserves No Longer Bind)
  12. 12Reading a Bank Income Statement
  13. 13Bank Capital, Tier 1 Ratios, and Stress Tests— reading now
  14. 14Yield Curve Shape and Bank Net Interest Margin
  15. 15How a Modern Bank Run Unfolds
  16. 16National Income Identities: Why S = I (and Y = C + I + G + NX)
  17. 17Current Account = Capital Account: Why Trade Deficits Are Capital Inflows
  18. 18Fiscal Multiplier Mechanics: Why $1 of Spending Becomes $0.50-$2 of GDP
  19. 19Exchange Rate Regimes and the Impossible Trinity
  20. 20Capital Flows and Sudden Stops: Why EM Crises Look Alike
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