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.