Reserve Bank explainer: Why banks need more tier 1 capital

Bank capital levels matter because it is what they can draw on if there is an unexpected financial disaster. Photo/Michael Craig.

The Reserve Bank wants New Zealand's banks to have more tier 1 capital.

But what is it and why does it matter so much?

Tier 1 capital is a bank's core capital and what protects it against unexpected financial losses.

It is made up of common equity tier 1 capital which is seen as the highest quality of capital and includes retained earnings - the money a bank keeps aside from making a profit and the shareholders investment or ordinary shares.

It also includes additional capital which is made up of preference shares although this is not seen to be as good as common equity.

The reason this capital matters is that if the bank gets into financial difficulty it can use these reserves to help itself get out of trouble.

It has to use this money before using creditors' funds - including depositors' money.

So the more tier 1 capital it has the less likely it will have to use depositor's money should something go wrong.

Regulators use tier 1 capital as a percentage of risk-weighted assets to work out a bank's capital ratio and whether it has adequate resources should something go wrong.

Rating agencies also use it to measure a bank's financial strength which in turn can tell depositors how safe it is to put their money in that bank.

There are minimum capital ratios set for banks all around the world by the Basel Committee on banking supervision.

These are updated regularly with the latest changes coming through in March this year and can take into account the impact of big events like the 2009 Global Financial Crisis and what banks need to buffer themselves against such an event.

But local regulators can also set their own rules on top of that.

At the moment the current minimum tier 1 common equity capital ratio set by the Reserve Bank of New Zealand for the big four banks - ANZ, ASB, BNZ and Westpac - is 8.5 per cent.

But to be safe and ensure they don't go below that minimum the banks also have a buffer on top of that.

The big four banks held common equity of 11.05 per cent at June 30, according to Reserve Bank figures.

The smaller banks have a different level of capital they have to hold because they are not seen as so systemically important as the big four banks.

If they were to collapse it wouldn't have as wide an impact as a larger bank.