Tier 2 Capital

Updated on April 5, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Tier 2 Capital?

In addition to Tier 1, Tier 2 is an additional component of the bank’s core capital base under the Basel accord, which includes revaluation reserves, undisclosed reserves, 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.read more to support bank’s total capital requirement.

Key Takeaways

Types of Tier 2 Capital

#1 – Undisclosed Reserves

Undisclosed or hidden reserves are those that have been passed through profit and loss accountProfit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization's revenue and costs incurred during the financial period and is indicative of the company's financial performance by showing whether the company made a profit or incurred losses during that period.read more and are accepted by the bank’s supervisory authorities. They may be as valuable and hold the same intrinsic value as other published retained earnings. Still, due to lack of transparency and the fact that some countries do not recognize reserves as accepted accounting practicesAccounting PracticesAccounting practice is a set of procedures and controls used by an entity's accounting department to keep track of accounting records and entries. Other reports are generated based on accounting records, such as financial statements, cash flow statements, fund flow statements, payroll, tax workings, payment and receipts statements, and so on, and they form the basis of the auditor's reliance while auditing the financial statements.read more, it is their opinion to exclude them from the core equity capital element.

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#2 – Subordinated Debt

The Basel committee has a different view about including it as tier 2 capital due to its fixed maturity and the inability to absorb losses except in the case of liquidation. However, it has been agreed that subordinated debt instrumentsSubordinated Debt InstrumentsIn case of liquidation of a company, rankings are provided to various debts for repayment, wherein the kind of debt which is ranked after all the senior debt and other corporate Debts and loans is known as subordinated debt, and the borrowers of such kind of debt are larger corporations or business entities.read more 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 a part of additional 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 that has not been incurred nor yet identified. As they do not reflect general 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 riskCountry RiskCountry risk denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a little rumour or revelation can make a state less attractive to investors who want to park their hard-earned income in a reliable place.read more, or if the provision is created to meet identified losses that arise subsequently in the portfolio, do 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.read more to reflect their 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.read more arises in two ways:

  1. From a formal revaluation carried through the balance sheet.
  2. Notional addition to the capital of hidden values which arise from holding securities in the balance balance sheet valued at historic costsBalance Sheet Valued At Historic CostsA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.
Tier 2 Capital

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Characteristics of Tier 2 Capital

#1 – No Change in Tier 2 Constituents

Basel IIIBasel IIIBasel III is a regulatory framework designed to strengthen bank capital requirements while also mitigating risk. It is an extension in the Basel Accords, designed and agreed upon by members of the Basel Committee on Banking Supervision.read moreincreased 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 planDefined Benefit Pension PlanA Defined Benefit Plan (DBP) is an employer-funded pension scheme set up to pay a pre-established amount on retirement to employees. Under this arrangement, a company takes full responsibility for planning its employees’ retirement fund. This plan offers the twin advantage of greater tax deductions to the sponsor company and a guaranteed retirement income to its employees.read more deficits but is not raised upward for surplus. 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.read more arising from bank’s credit risksCredit RisksCredit risk is the probability of a loss owing to the borrower's failure to repay the loan or meet debt obligations. It refers to the possibility that the lender may not receive the debt's principal and an interest component, resulting in interrupted cash flow and increased cost of collection.read more called debt value adjustments or arising from the securitized transaction.

Tier 2 supplementary capital includes debt subordinated to depositors with an original maturity of 5 years or more and cumulative perpetual preferred stockPreferred StockA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more. 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.
  • 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.
  • Total Capital including Tier1 and Tier2 capital must be at least 8% of risk-weighted assets all the time.



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. read more strength. However, Tier 2 capital does not comprise the firm’s capital as dividends or interests need to be paid periodically. 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.read more may result in the default of the company.


Tier II items are qualified as regulatory capital as it helps the firm to carry out its day on daily business activities. However, the firm has to meet its obligation of dividendDividendDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, interest and principal repayment failure, which may result in default.

This has been a guide to Tier 2 capital and its definition. Here we discuss the characteristics and types of tier 2 capital and its advantages and disadvantages. You can learn more about accounting from the following articles –

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