What is Tier 2 Capital?
In addition to Tier 1, Tier 2 is a supplementary component of the bank’s core capital base under Basel accord which includes revaluation reserves, undisclosed reserve, hybrid instruments, and subordinated debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans. to support bank’s total capital requirement.
- However, some countries require banks to have more capital than required by the accord at the discretion of bank supervisors.
- Banks on and off-balance sheet items had to be used to calculate risk-weighted assets (RWA). RWA is intended to measure bank total market, credit and operation exposure Risk-based capital requirement was key change to capital regulation.
- Basel 3 accord includes capital conservation buffer as a part of the total capital requirement to protect banks in times of financial crises. Banks are required to build up a buffer of Tier1 equity capital equal to 2.5% of risk-weighted assets in normal times which will be then used to cover losses during the stress period.
- This means that in normal times a bank should have a minimum of 7% of tier 1 equity capital and total capital which is adding tier 1 and tier 2 must be equal to 10.5% risks weighted assets.
Types of Tier 2 Capital
#1 – Undisclosed Reserves
Undisclosed or hidden reserve are those reserve which has been passed through profit and loss account and are accepted by banks supervisory authorities. They may be as valuable and hold same intrinsic value as other published retained earnings but due to lack of transparency and the fact that some countries do not recognize reserves as accepted accounting practices, they are in opinion to exclude it from core equity capital element.
#2 – Subordinated Debt
The basal committee has a different view with regard to include it as tier 2 capital due to the fact of their fixed maturity and is the inability to absorb losses except in case of liquidation. However, it has been agreed that subordinated debt instruments should have a minimum maturity of at least five years to be included in supplementary capital elements.
#3 – Hybrid Debt Instruments
These instruments include the characteristics of both debt and equity instruments. They are considered to be a part of supplementary capital because of their ability to support losses on an ongoing basis without triggering liquidation just like equities capital.
#4 – General Provision / General Loan Reserves
These reserves are created against the possibility of loss which has not been incurred nor yet identified. As they do not reflect known deterioration in the valuation of particular assets these reserves can constitute part of Tier 2 capital. However, provisions or reserves created against identified losses or an identified deterioration in the value of any asset or group of assets subject to country risk, or if the provision is created to meet identified losses that arise subsequently in the portfolio does not constitute part of the reserves.
#5 – Revaluation Reserves
Some assets are revaluedAssets Are RevaluedAssets revaluation is an adjustment made in the carrying value of the fixed asset, either upwards or downwards, depending upon the fair market value of the fixed asset. Its purpose includes selling the asset to another business unit, merger and acquisition. to reflect its current value or something closer to their current value rather than historic costs should be included under Tier 2 capital. Revaluation reserveRevaluation ReserveA revaluation reserve is a non-cash reserve created to reflect the asset's true value when the market value of a certain asset category is more or less than the asset's value at which it is recorded in the books of account. arises in two ways:
- From a formal revaluation carried through the balance sheet.
- Notional addition to the capital of hidden values which arise from the practice of holding securities in balance sheet valued at historic costs.
Characteristics of Tier 2 Capital
#1 – No Change in Tier 2 Constituents
Basel III increased capital risk and tightened the definition of capital in response to the 2007-2009 financial crises. Tier 1 capital should be adjusted downward to reflect defined benefit pension plan deficits but is not raised upward for surplus and it also excludes changes in retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company. arising from bank’s credit risks called debt value adjustments or arising from the securitized transaction.
Whereas Tier 2 supplementary capital includes debt subordinated to depositors with an original maturity of 5 years or more and cumulative perpetual preferred stock. There was no change in tier 2 constituents.
#2 – Capital Requirements in Basel III
- Tier 1 equity capital must be 4.5% of risk-weighted assets at all times.
- Total Tier 1 capital such as equity capital plus additional tier 1 capital such as preferred perpetual stock must be 6% of risk-weighted assets at the time.
- Total Capital including Tier1 and Tier2 capital must be at least 8% of risk-weighted assets all the time.
- Regulatory Relaxation: Supplementary capital is subordinate to depositors and thus protects depositors in the event of bank failure whereas equity capital absorbs losses. At least 50% of the total capital must be Tier 1 as per the regulatory requirement. This means is a 4% tier 1 capital to risk-weighted assetsRisk-weighted AssetsRisk-weighted asset refers to the minimum amount that a bank or any other financial institution must maintain to avoid insolvency or bankruptcy risk. The risk associated with each bank asset is analyzed individually to figure out the total capital requirement. requirement (i.e. 8% *0.5) i.e. half of the tier 1 requirement must be met with common equity. No such requirement was implemented for Tier 2 Capital.
- Last Resort in Case of Liquidation: Common equity is known as going concern capital. It absorbs losses when the bank has positive equity. (going concern) Tier 2 capital is gone concern capital. When the bank has negative capital and is no longer going concern, it helps to absorb losses. Depositors are ranked above Tier2 capital as long as Tier2 capital is positive, depositors should be paid in full.
Tier 2 Capital is Burden to Firm Assets: Tier 1 capital is regarded as a bank’s own capital as the money helps a bank to fund its ongoing regular operations and forms the basis of a financial institution’sFinancial Institution'sFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. strength. However, Tier 2 capital does not comprise of firm own capital as dividends or interests need to pay on a periodic basis. Failure to pay principal or accrued interestAccrued InterestAccrued Interest is the unsettled interest amount which is either earned by the company or which is payable by the company within the same accounting period. may result in the default of the company.
Tier II items are qualified as regulatory capital as it helps the firm can carry out its day on daily business activities. However, the firm has to meet its obligation of dividendDividendDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company., interest and principal repayment failure to which may result in default.
This has been a guide to what is Tier 2 capital and its definition. Here we discuss characteristics and types of tier 2 capital along with its advantages and disadvantages. You can learn more about accounting from the following articles –