In an attempt to prevent organisations such as banks from going bust too easily, regulators impose minimum capital requirements on them: a bank should ensure that its own funds – (capital that it can count as its own) as a proportion of “risk-weighted assets” (money it is owed by other people, allowing for non-payment risk) exceeds a regulatory target. A regulator can vary this target – the riskier the bank, the higher the target.
A bank’s “own funds” can be subdivided into different tiers, with “tier one” representing capital of the highest quality – typically funds raised from issuing shares, combined with past profits. So suppose a bank issued $100 of shares ten years ago and has made $100 of profit over the last decade, its “own funds” would be $200.
Now assume that it is owed $1,600 as a result of lending to third parties and the regulator has set a tier one target of 10%. Well, 200/1,600 is 12.5%, which beats the target – so all is well (hopefully).
