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Tier 1 capital is a measurement of the overall monetary power of a financial institution. In this case, common stock is the stock issued by the firm and traded over the primary market in order to raise capital. Originally, tier 1 value was determined largely through the firm’s initial offering of common stock plus retained earnings. This has slowly modified over the years, and now several factors come together to determine total tier 1 capital, although a very large portion is still made up of common stock. Now, a weighted value of money lent by the institution and portion of external investment also play an important role.
A large part of tier 1 capital is made of the value of the firm’s common stock. This stock is valued at the amount that it sold for initially on the primary market; essentially, the value it held the very first time it was sold. When the market causes the value of the stock to fluctuate, the changes have no effect on the value of the stock for determining tier 1 value.
As the firm makes money, the value given by the stock doesn’t change, but it continues to impact the total tier 1 capital. When a financial firm turns a profit, that money may be used by the firm or given to investors as a dividend. Money given as a dividend is considered lost as far as capital is concerned and is no longer counted. When the money is reinvested into the firm, the total reinvestment is added to the capital.
Originally, these two factors made up the entirety of tier 1 capital. In the later part of the 20th century, changes came into effect that broadened the overall measurement of the capital value. Now, a financial institution may count money that it has lent out or has invested in other firms. These debits and investments are weighted based on how the money is invested and with whom. The full amount of money is rarely added directly to capital; usually, a straight percentage is removed first.
As with all forms of capital, before a final value is determined, losses are removed. This was one of the major stumbling blocks in tier 1 capital as many of a financial firm’s debts are actually money lent out rather than true loses. The policy reforms alleviated some of these concerns by restructuring exactly what were considered assets and what were debts in relation to banks. Now, all of these factors come together — common stock, reinvested income, lent money and overall debt — to determine the true tier 1 capital value.
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