CET1 Modelling
Executive Summary
Key Takeaways
- ✓ CET1 capital should be built from its eligible components — common shares, retained earnings, and certain qualifying reserves — with regulatory deductions applied explicitly and separately, not netted into a single opaque figure.
- ✓ Common deductions include goodwill, certain deferred tax assets that rely on future profitability, and other intangible assets, since these do not represent loss-absorbing capacity available to a bank in stress.
- ✓ The CET1 balance should roll forward period over period from retained current-period earnings, any new share issuance, and any distributions, connecting directly to the model's own income statement and equity roll-forward rather than existing as a disconnected assumption.
- ✓ A bank model does not itself validate whether a specific deduction is correctly applied under the relevant regulatory framework — it should represent the deduction categories as visible, sourced assumptions.
- ✓ CET1 modelled without its deductions overstates true loss-absorbing capital and produces a CET1 ratio that misrepresents the bank's actual regulatory capital position.
Objective¶
This guide covers how to build the Common Equity Tier 1 (CET1) capital numerator, within Capital Adequacy Models, feeding the CET1 Ratio that anchors the Basel capital framework — see Basel Capital Ratios.
Eligible Components¶
CET1 capital is built from its highest-quality, most loss-absorbing components:
| Component | Description |
|---|---|
| Common shares and paid-in surplus | Ordinary share capital issued, including any premium paid above par value |
| Retained earnings | Accumulated profit retained in the business, net of distributions |
| Qualifying reserves | Certain reserves the applicable regulatory framework recognizes as eligible, subject to its specific treatment |
Regulatory Deductions¶
Specific items are deducted from the gross eligible components because they do not represent genuine loss-absorbing capacity available in stress:
| Deduction | Rationale |
|---|---|
| Goodwill | An accounting asset with no realizable value in a stress or wind-down scenario |
| Other intangible assets | Similarly limited realizable value in stress |
| Certain deferred tax assets | Value depends on future profitability, which cannot be relied upon as loss-absorbing capacity during stress |
Each deduction should be shown explicitly and separately, not netted into a single opaque "net CET1 capital" line. Explicit presentation lets a reviewer confirm which deductions were applied and whether the set is complete, rather than accepting a net figure on faith.
CET1 Capital = Common Shares + Paid-in Surplus + Retained Earnings + Qualifying Reserves
− Goodwill − Other Intangibles − Disallowed Deferred Tax Assets − Other Applicable Deductions
Roll-Forward Discipline¶
The CET1 balance should roll forward period over period directly from the model's own income statement and equity movements:
Closing CET1 = Opening CET1
+ Current-Period Retained Earnings
+ New Share Issuance
− Distributions / Buybacks
± Change in Applicable Deductions
Connecting this roll-forward directly to the model's income statement and equity schedule — rather than treating CET1 as a disconnected, separately maintained assumption — ensures the capital base used in the ratio calculation is always consistent with the rest of the model's own results.
Scope of This Guide¶
This guide describes how CET1 should be structured and built within a financial model. It does not describe FMAE performing or validating whether a specific deduction is applied correctly under a given jurisdiction's regulatory framework — that determination remains outside the structural audit engine's scope.
Common Construction Pitfalls¶
- Presenting CET1 as a single net figure without showing the eligible components and deductions separately.
- Omitting standard deductions (goodwill, disallowed deferred tax assets) entirely, overstating loss-absorbing capital.
- Maintaining the CET1 balance as a disconnected assumption rather than rolling it forward from the model's own retained earnings and equity movements.
- Holding deduction assumptions static rather than updating them as the underlying balance sheet items (goodwill from an acquisition, deferred tax positions) change.
Continue Reading¶
Prerequisites¶
- Capital Adequacy Models — the parent guide
- Basel Capital Ratios
Related Glossary¶
Related Technical Guides¶
How OXXON tests thisRun a free structural check with FMAE
Frequently Asked Questions
What is Common Equity Tier 1 (CET1) capital?
The highest-quality, most loss-absorbing layer of a bank's regulatory capital, composed principally of common shares and retained earnings, net of specific regulatory deductions — the numerator of the CET1 ratio, the most closely watched Basel capital ratio.
What are the typical eligible components of CET1 capital?
Common shares issued and paid-in surplus, retained earnings, and certain qualifying reserves (such as accumulated other comprehensive income, subject to the applicable framework's treatment).
What are the typical deductions from CET1 capital?
Goodwill and other intangible assets, certain deferred tax assets that rely on future profitability to be realized, and other specific items the applicable regulatory framework identifies as not representing genuine loss-absorbing capacity.
Why does it matter that deductions are shown explicitly rather than netted?
Because a single opaque "net CET1 capital" figure prevents a reviewer from confirming which specific deductions were applied and whether they are complete and correctly sourced — showing each component and deduction separately makes the build auditable.
How should the CET1 balance roll forward period over period?
From the model's own retained current-period earnings, any new share issuance, and any distributions or buybacks: Opening CET1 + Retained Earnings + New Share Issuance − Distributions − Change in Deductions = Closing CET1, connecting directly to the income statement and equity roll-forward rather than existing as a disconnected assumption.
Does FMAE validate whether a specific CET1 deduction is correctly applied?
No — FMAE structurally audits a model's own formulas and logic, not whether a given regulatory deduction is applied correctly under a specific jurisdiction's rules. This guide describes how the deduction categories should be represented as visible, sourced model assumptions.
Related Articles
Capital Adequacy Models
Capital adequacy modelling represents the constraint regulatory capital requirements place on how much risk-weighted balance sheet a bank can carry against its available capital base. This guide covers how to structure a capital adequacy model — the capital tiers, the risk-weighted asset base they are measured against, minimum ratio and buffer requirements — and how it should be built as a live check against the balance sheet forecast rather than a standalone reporting exercise calculated after the forecast is already complete.
Basel Capital Ratios
The Basel III framework defines three core capital ratios — Common Equity Tier 1, Tier 1, and total capital — each measured against risk-weighted assets, layered with additional capital buffers above the hard minimums. This guide sets out the ratio definitions, the minimum and buffer levels the framework establishes, and how a bank model should represent each ratio and buffer as a distinct, named threshold rather than a single blended capital requirement.
CET1 Ratio
The CET1 ratio expresses Common Equity Tier 1 capital — a bank's highest-quality, most loss-absorbing capital — as a percentage of risk-weighted assets. It is the most closely watched capital adequacy metric under Basel III, subject to both a hard minimum requirement and additional capital buffers, and it should be built as a live output of the model's balance sheet forecast rather than a separately calculated reporting figure.
Risk Weighted Assets
Risk-weighted assets (RWA) convert a bank's balance sheet exposures into a common risk-adjusted base, applying higher weights to riskier exposures and lower weights to safer ones. RWA forms the denominator of every Basel capital ratio, making the risk-weighting methodology a first-order driver of reported capital strength. This guide covers the standardized and internal ratings-based (IRB) approaches to calculating RWA, how a model should build the RWA base from segmented exposures, and how risk-weight density should be tracked as its own diagnostic output.
Balance Sheet Forecasting
Balance sheet forecasting is the central forward-looking exercise in a bank model: forecasting segmented asset volumes (loans, securities) and liability volumes (deposits, wholesale funding) period by period, then reconciling the two through an explicit funding plan. This guide covers how to structure that forecast, how to build the funding plan that closes any gap between asset growth and deposit growth, and how the forecast should be checked against capital adequacy and liquidity constraints rather than produced in isolation from them.