Loading the player...

What is 'Tier 2 Capital'

Tier 2 capital is the secondary component of bank capital, in addition to Tier 1 capital, that makes up a bank's required reserves. Tier 2 capital is designated as supplementary capital, and is composed of items such as revaluation reserves, undisclosed reserves, hybrid instruments and subordinated term debt. In the calculation of a bank's reserve requirements, Tier 2 capital is considered less secure than Tier 1 capital, and in the United States, the overall bank capital requirement is partially based on the weighted risk of a bank's assets.

BREAKING DOWN 'Tier 2 Capital'

Laws governing bank capital requirements stem from the international Basel Accords, a set of recommendations from the Basel Committee on Bank Supervision. Under the Basel Accords, a bank's capital is divided into Tier 1 core capital and Tier 2 supplementary capital. The minimum capital ratio reserve requirement for a bank is set at 8%, 6% of which must be provided by Tier 1 capital. A bank's capital ratio is calculated by dividing the bank's capital by its total risk-based assets.

Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult to accurately calculate and composed of assets that are more difficult to liquidate. It is commonly split into two levels: upper and lower. Upper level Tier 2 capital has the characteristics of being perpetual, and senior to preferred capital and equity. It also has cumulative, deferrable coupons and interest and principal that can be written down. Lower level Tier 2 capital is characterized by being inexpensive for a bank to issue, having coupons that are not deferrable without triggering default, and includes subordinated debt with a minimum five-year maturity.

The Components of Tier 2 Capital

The first component of Tier 2 capital is revaluation reserves, which are reserves created by the revaluation of an asset. A typical revaluation reserve is a building owned by the bank. Over time, the value of the real estate asset tends to increase and can thus be revalued.

The second component is general provisions. These are losses a bank may have of an as yet undetermined amount. The total general provision amount allowed is 1.25% of the bank's risk-weighted assets (RWA).

The third element is hybrid capital instruments that have mixed characteristics of both debt and equity instruments. Preferred stock is an example of hybrid instruments. A bank may include hybrid instruments in its Tier 2 capital as long as the assets are sufficiently similar to equity so losses can be taken on the face value of the instrument without triggering liquidation of the bank.

The final component of Tier 2 capital under U.S. regulations is subordinated term debt with a minimum original term of five years or more. The debt is subordinated in regard to ordinary bank depositors and other loans and securities that constitute higher-ranking senior debt.

Most countries, including the United States, do not allow undisclosed reserves, which are profits not stated in a bank's reserve, to be used to meet reserve requirements.

RELATED TERMS
  1. Tier 3 Capital

    Tertiary capital held by banks to meet part of their market risks, ...
  2. Tier 1 Capital

    A term used to describe the capital adequacy of a bank. Tier ...
  3. Tier 1 Common Capital Ratio

    A measurement of a bank's core equity capital compared with its ...
  4. Tier 1 Capital Ratio

    A comparison between a banking firm's core equity capital and ...
  5. Bank Capital

    The difference between the value of a bank's assets and its liabilities. ...
  6. Basel III

    A comprehensive set of reform measures designed to improve the ...
Related Articles
  1. Personal Finance

    What's Tier 2 Capital?

    Tier 2 capital is a category of supplementary capital that banks hold.
  2. Small Business

    Understanding the Capital Adequacy Ratio

    The capital adequacy ratio (CAR) is an international standard that measures a bank’s risk of insolvency from excessive losses. Currently, the minimum acceptable ratio is 8%. Maintaining an acceptable ...
  3. Personal Finance

    Calculating the Tier 1 Capital Ratio

    The Tier 1 capital ratio is a measure of a depository financial institution’s financial health and capital adequacy.
  4. Investing

    Calculating Tier 1 Common Capital Ratio

    The tier 1 common capital ratio compares a financial institution’s core equity capital to its risk-weighted assets.
  5. Investing

    Using Economic Capital To Determine Risk

    Discover how banks and financial institutions use economic capital to enhance risk management.
  6. Investing

    The Legacy of Basel I

    Basel I refers to a set of international banking rules enacted in 1988 by the Basel Committee on Bank Supervision.
  7. Trading

    Why These Are 2015's 10-Best Financial Stocks

    If you're going to invest in the financial stocks, these names need to be on your radar.
  8. Managing Wealth

    An Investor's Guide To Bank Stress-Testing

    Just how are bank stress tests performed and what is the logic behind them? And is a stress test useful for evaluating a bank's stock?
  9. Investing

    Assessing Bank Assets: Are Your Savings Safe?

    Learn how to determine if your assets are safe or if your bank has spread itself too thin.
  10. Investing

    My Mini-IPO: The Reality of Equity Crowdfunding

    Regulation A+, part of Title IV of the JOBS Act, has made equity crowdfunding a reality in the U.S. What does that mean for investors and entrepreneurs?
RELATED FAQS
  1. What is the difference between tier 1 capital and tier 2 capital?

    Learn what tier 1 capital and tier 2 capital, the differences between them, and how to calcu, alate a bank's capital ratio. Read Answer >>
  2. How can I calculate the leverage ratio using tier 1 capital?

    Learn about the tier 1 leverage ratio, how to calculate the tier 1 capital ratio and what this leverage ratio indicates about ... Read Answer >>
  3. How do I calculate the capital to risk weight assets ratio for a bank in Excel?

    Learn more about the capital to risk-weighted assets ratio and how to calculate a bank's capital adequacy ratio using Microsoft ... Read Answer >>
  4. What is the minimum capital adequacy ratio that must be attained under Basel III?

    Find out more about the capital adequacy ratio, or CAR, and the minimum capital adequacy ratio that banks must attain under ... Read Answer >>
  5. What average annual growth rate is typical for the banking sector?

    Learn the typical average annual growth rate for the banking sector and why regulatory requirements have a profound effect ... Read Answer >>
  6. How does Basel III strengthen regulation and improve risk management of the global ...

    Learn about the banking regulations of Basel III, including provisions regarding capital, leverage ratios and liquidity requirements. Read Answer >>
Trading Center