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 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.
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 of 10%, so all is well.