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Capital distributed as per predefined standards helps in financial risk management as the lender restrains unjustified asset expansion and banks hold deposits that help institutions at the time when they fail to perform in business.
Such deposits help to reduce potential moral hazards.
It is the core capital that a bank holds in its reserves through activities like lending, investment, and trading.
It mostly involves the capital held in assets that can provide enough money to fulfill needs like common stocks, preferred stocks, and retained earnings.
It provides the reserves and the primary source of funds.
It indicates the assets a bank holds to continue providing funds for the business needs of the customer.
It can be held to show the strength of a bank that measures the financial preparedness of the financial institution to handle emergencies.
Not all types of assets and investments are risky. Like the money is ATM is safer than mortgages.
The risk factors have been divided into Tiers where Tier1 include total shareholder equity, non-MSR intangibles, certain hybrid securities, controlling interests, accumulated other comprehensive income (AOCL) and the regulatory deductions or adjustments and the qualifying common equity tier 1 minority interests and the federal banking agencies expect the majority of the common equity tier 1 capital to be in the form of common voting shares.
Common equity Tier 1 capital is the most loss-absorbing form of capital and it involves common stocks, treasury stocks, and retained earnings.
Tier 2 capital includes the allowance for loan and lease losses as a percent of right weighted assets, subordinated debt, qualifying preferred stocks, and qualifying tier 2 minority interests.
If a bank invests is the instrument that qualifies as tier 2 capital, it is deducted from tier 2 capital.
If it qualifies as tier 1, it is deducted from tier 1 and if it qualifies as common equity tier 1, it is deducted from common equity tier 1.
If the bank does not have sufficient tier 2 capital to absorb deduction, then the excess is deducted from additional tier 1 or for common equity tier 1 – if the additional tier 1 capital is not adequate.
The alternative investment instruments like common stocks or preferred stocks are deducted from each tier of the capital, however, the investment must analyze whether it is significant or not and it depends on the percent of common stock the bank owns in other financial companies.
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