What Is Tier 2 Capital?
Let me explain what Tier 2 capital means—it's one key part of the reserves that banks are required to hold. You see, Tier 2 acts as the second or supplementary layer of a bank's capital, including things like revaluation reserves, hybrid instruments, and subordinated term debt. It's not as secure as Tier 1 capital, the primary form, because it's tougher to turn into cash quickly. In the US, the total capital a bank needs is based partly on the risk level of its assets, weighted accordingly.
Key Takeaways
Here's what you need to know right away: Tier 2 capital forms the second layer of reserves a bank must maintain. It includes revaluation reserves, general provisions, subordinated term debt, and hybrid capital instruments. Remember, there are upper and lower levels of Tier 2 capital. Overall, it's subordinate to Tier 1 and riskier because it's harder to calculate and liquidate if the bank faces trouble.
Understanding Tier 2 Capital
Bank capital rules come from the international Basel Accords, developed by the Basel Committee on Bank Supervision starting in the 1980s. These require banks to keep a certain amount of cash or liquid assets to cover obligations, and Tier 2 can't make up more than 25% of those requirements.
We divide bank capital into Tier 1 (core) and Tier 2 (supplementary). You calculate the capital ratio by dividing capital by total risk-weighted assets, with a minimum of 8%—at least 6% from Tier 1, the rest from Tier 2. This setup gives banks a buffer if they need to sell assets.
Tier 2 has four main components. Revaluation reserves come from increasing the value of assets like a bank-owned building over time. General provisions cover potential losses, like from loans, limited to 1.25% of risk-weighted assets. Hybrid capital instruments mix debt and equity, such as preferred stock, and must resemble equity enough to absorb losses without forcing liquidation. Subordinated debt ranks below regular depositors and senior debt, with a minimum term over five years.
We further split Tier 2 into upper and lower levels. Upper Tier 2 includes perpetual securities without maturity, revaluation reserves, and fixed asset investments. Lower Tier 2 is subordinated debt, which is cheaper for banks to issue.
Special Considerations
In some countries, undisclosed reserves—profits not shown on public documents like balance sheets—can count as Tier 2 capital. Banks view these as real assets, but most places, including the US, don't allow them to meet reserve requirements.
Tier 2 Capital vs. Tier 1 Capital
As I mentioned, capital reserves split into tiers. Tier 1 is the core capital, the main funding source, including disclosed reserves and equity like common stock. It absorbs losses so the bank keeps operating daily. Tier 1 indicates financial health better because it's easier to calculate and liquidate. Tier 2 is less reliable in comparison.
What Is Tier 3 Capital?
Tier 3 capital is a tertiary type that banks use for market risk in trading. It includes more varied debt like short-term unsecured subordinated debt, but it's lower quality. Under Basel III, Tier 3 is being phased out.
What Is Basel II?
Basel II is the second set of Basel Accords, setting international standards to regulate banks and cut system risks. It built on Basel I by clarifying rules and adding new ones, leading to Basel III to fix earlier shortcomings.
What Is the Minimum Capital Adequacy Under Basel II?
Under Basel II, banks need to hold capital reserves (Tiers 1, 2, and 3) at least 8% of their risk-weighted assets.
The Bottom Line
The Basel Accords mandate banks to hold various capital types in specific percentages. This balances out risky assets and stabilizes the financial system. Tier 2 is supplementary capital in reserve, less reliable than Tier 1 due to liquidation challenges and measurement difficulties.
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