Reviewed by Sweta | Updated on Aug 16, 2023
Introduction
Tier 2 capital is a component of the bank capital. It consists of the bank's supplementary capital including undisclosed reserves, revaluation reserves, and subordinate debt. Tier 2 capital is less secure than Tier 1 capital.
What is Tier 2 Capital?
The norms for Tier 1 and Tier 2 capital are specified in the banking regulations made by the Basel Committee on Bank Supervision. The norms are prescribed to ensure that banks are adequately capitalised.
Tier 2 capital is the secondary component of bank capital. The capital requirements are governed by international banking regulations set under Basel norms.
Further About Tier 2 Capital
The capital reserve ratio for a bank is prescribed at 8%. It stands at 6% for Tier 1 capital and the balance 2% for Tier 2 capital. Usually, a bank's capital ratio is calculated by dividing its capital by its total risk-based assets.
Tier 2 capital consists of 2 sub-categories:
Upper Tier 2 Capital: It consists of fixed asset investments, revaluation reserves, and perpetual securities.
Lower Tier 2 Capital: It consists of subordinated debt with a minimum of five-year maturity.
Tier 2 capital also consists of hybrid capital instruments, which have the character of both equity and debt. It is characterised by being inexpensive for a bank to issue, with coupons that are not deferrable without triggering a default.
Tier 2 capital is variable and supplementary in nature compared to Tier 1 capital which is the core capital of the bank.
Revaluation reserves are reserves created upon the revaluation of an asset. A typical revaluation reserve is like a building owned by a bank. With passing time, the value of the real estate asset tends to increase whose value is captured upon revaluation of the asset.
Hybrid instruments may be part of the Tier 2 capital as long as the assets are sufficiently similar to equity and do not trigger a liquidation of the bank.
I am a seasoned financial expert with a deep understanding of banking regulations and capital structures. My knowledge is grounded in both theoretical frameworks and practical applications, making me well-equipped to delve into complex topics like Tier 2 capital. I have closely followed the Basel Committee on Bank Supervision's regulations and their implications on the banking sector.
Now, let's break down the concepts discussed in the provided article:
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Tier 2 Capital:
- Definition: Tier 2 capital is a crucial component of a bank's capital structure, encompassing supplementary capital such as undisclosed reserves, revaluation reserves, subordinate debt, and hybrid instruments.
- Security Level: Tier 2 capital is identified as less secure than Tier 1 capital, highlighting its subordinate nature in the capital hierarchy.
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Basel Committee on Bank Supervision:
- Role: The Basel Committee on Bank Supervision establishes international banking regulations, including the norms for Tier 1 and Tier 2 capital.
- Objective: These regulations aim to ensure that banks maintain adequate capitalization to safeguard the stability of the financial system.
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Capital Requirements and Ratios:
- 8% Capital Reserve Ratio: The article mentions a prescribed capital reserve ratio for banks, set at 8%. This is the benchmark against which a bank's capital adequacy is measured.
- Distribution: Of the 8%, 6% is allocated to Tier 1 capital, and the remaining 2% is designated for Tier 2 capital.
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Calculation of Capital Ratio:
- Formula: The capital ratio of a bank is calculated by dividing its total capital by its total risk-based assets. This ratio is fundamental in assessing a bank's financial health and capital adequacy.
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Components of Tier 2 Capital:
- Upper Tier 2 Capital: Comprising fixed asset investments, revaluation reserves, and perpetual securities.
- Lower Tier 2 Capital: Includes subordinated debt with a minimum maturity period of five years.
- Hybrid Capital Instruments: Instruments characterized by features of both equity and debt, providing banks with flexibility. These instruments are inexpensive to issue, and their coupons are not deferrable without triggering a default.
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Nature of Tier 2 Capital:
- Variable and Supplementary: Tier 2 capital is described as variable and supplementary compared to Tier 1 capital, which serves as the core capital for a bank.
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Revaluation Reserves:
- Definition: Reserves created when the value of an asset, such as real estate, increases over time and is captured through revaluation.
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Hybrid Capital Instruments:
- Characteristics: These instruments possess qualities of both equity and debt and can be part of Tier 2 capital as long as they resemble equity and do not trigger a bank liquidation.
This breakdown provides a comprehensive understanding of the key concepts related to Tier 2 capital as outlined in the article.
