Under the Basel Accord, a bank has to maintain a certain level of cash or liquid assets as a ratio of its risk-weighted assets. The Basel Accords are a series of three sets of banking regulations that help to ensure financial institutions have enough capital on hand to handle obligations. The Accords set the capital adequacy ratio (CAR) to define these holdings for banks. Under Basel III, a bank's tier 1 and tier 2 assets must be at least 10.5% of its risk-weighted assets. Basel III increased the requirements from 8% under Basel II.

Key Takeaways

  • Under Basel III, a bank's tier 1 and tier 2 assets must be at least 10.5% of its risk-weighted assets, up from 8% under Basel II.
  • Tier 1 capital is the primary funding source of the bank.
  • Tier 1 capital consists of shareholders' equity and retained earnings. 
  • Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves.
  • Tier 2 capital is considered less reliable than Tier 1 capital because it is more difficult to accurately calculate and more difficult to liquidate.

Tier 1 Capital vs. Tier 2 Capital: An Overview

A bank's capital consists of tier 1 capital and tier 2 capital, and these two primary types of capital reserves are qualitatively different in several respects (there was formerly a third type, conveniently called tier 3 capital).

  • Tier 1 capital is a bank's core capital and includes disclosed reserves—that appears on the bank's financial statements—and equity capital. This money is the funds a bank uses to function on a regular basis and forms the basis of a financial institution's strength.
  • Tier 2 capital is a bank's supplementary capital. Undisclosed reserves, subordinated term debts, hybrid financial products, and other items make up these funds.

A bank's total capital is calculated by adding its tier 1 and tier 2 capital together. Regulators use the capital ratio to determine and rank a bank's capital adequacy.

Tier 1 Capital

Tier 1 capital consists of shareholders' equity and retained earnings—disclosed on their financial statements—and is a primary indicator to measure a bank's financial health. These funds come into play when a bank must absorb losses without ceasing business operations. Tier 1 capital is the primary funding source of the bank. Typically, it holds nearly all of the bank's accumulated funds. These funds are generated specifically to support banks when losses are absorbed so that regular business functions do not have to be shut down.

Under Basel III, the minimum tier 1 capital ratio is 10.5%, which is calculated by dividing the bank's tier 1 capital by its total risk-weighted assets (RWA). RWA measures a bank's exposure to credit risk from the loans it underwrites.

For example, assume there a financial institution has US$200 billion in total tier 1 assets. They have a risk-weighted asset value of 1.2 trillion. To calculate the capital ratio, they divide $200 billion by $1.2 trillion in risk for a capital ratio of 16.66%, well above the Basel III requirements.

Also, there are further requirements on sources of the tier 1 funds to ensure they are available when the bank needs to use them.

Tier 2 Capital

Tier 2 capital includes undisclosed funds that do not appear on a bank's financial statements, revaluation reserves, hybrid capital instruments, subordinated term debt—also known as junior debt securities—and general loan-loss, or uncollected, reserves. Revalued reserves is an accounting method that recalculates the current value of a holding that is higher than what it was originally recorded as such as with real estate. Hybrid capital instruments are securities such as convertible bonds that have both equity and debt qualities.

Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital. It is more difficult to accurately measure due to its composition of assets that are difficult to liquidate. Often banks will split these funds into upper and lower level pools depending on the characteristics of the individual asset.

In 2019, under Basel III, the minimum total capital ratio is 12.9%, which indicates the minimum tier 2 capital ratio is 2%, as opposed to 10.9% for the tier 1 capital ratio. Assume that same bank reported tier 2 capital of $32.526 billion. Its tier 2 capital ratio for the quarter was $32.526 billion/$1.243 trillion = 2.62%. Thus, its total capital ratio was 16.8%(14.18% + 2.62%). Under Basel III, the bank met the minimum total capital ratio of 12.9%.

Tier 3 Capital

Previously the tiers of capital included a third layer. Tier 3 capital is tertiary capital, which many banks hold to support their market risk, commodities risk, and foreign currency risk, derived from trading activities. Tier 3 capital includes a greater variety of debt than tier 1 and tier 2 capital but is of a much lower quality than either of the two. Under the Basel III accords, tier 3 capital is being completely abolished.