What Is Tier 3 Capital?

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.

Key Takeaways

  • Tier 3 capital is capital banks hold to support market risk in their trading activities.
  • Unsecured, subordinated debt makes up tier 3 capital and is of lower quality than tier 1 and tier 2 capital.
  • The Basel Accords stipulate that tier 3 capital must not be more than 2.5x a bank's tier 1 capital nor have less than a two-year maturity.
  • The Basel II Accords outlined the need for tier 3 capital and under Basel III, tier 3 capital is being eliminated.

Understanding Tier 3 Capital

Tier 3 capital debt may include a greater number of subordinated issues when compared with tier 2 capital. Defined by the Basel II Accords, to qualify as tier 3 capital, assets must be limited to no more than 2.5x a bank's tier 1 capital, be unsecured, subordinated, and whose original maturity is no less than two years.

Tier 3 Capital and the Basel Accords

Capital tiers for large financial institutions originated with the Basel Accords. These are a set of three (Basel I, Basel II, and Basel III) regulations, which the Basel Committee on Banking Supervision (BCBS) began to roll out in 1988. In general, all of the Basel Accords provide recommendations on banking regulations with respect to capital risk, market risk, and operational risk.

The goal of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. While violations of the Basel Accords bring no legal ramifications, members are responsible for the implementation of the accords in their home countries.

Basel I required international banks to maintain a minimum amount (8%) of capital, based on a percent of risk-weighted assets. Basel I also classified a bank's assets into five risk categories (0%, 10%, 20%, 50%, and 100%), based on the nature of the debtor (e.g., government debt, development bank debt, private-sector debt, and more).

In addition to minimum capital requirements, Basel II focused on regulatory supervision and market discipline. Basel II highlighted the division of eligible regulatory capital of a bank into three tiers.

BCBS published Basel III in 2009, following the 2008 financial crisis. Basel III seeks to improve the banking sector's ability to deal with financial stress, improve risk management, and strengthen a bank's transparency. Basel III implementation has been pushed back till 2022.

Tier 1 Capital, Tier 2 Capital, and Tier 3 Capital

Tier 1 capital is a bank's core capital, which consists of shareholders' equity and retained earnings; it is of the highest quality and can be liquidated quickly. This is the real test of a bank's solvency. Tier 2 capital includes revaluation reserves, hybrid capital instruments, and subordinated debt. In addition, tier 2 capital incorporates general loan-loss reserves and undisclosed reserves.

Tier 1 capital is intended to measure a bank's financial health; a bank uses tier 1 capital to absorb losses without ceasing business operations. Tier 2 capital is supplementary, i.e., less reliable than tier 1 capital. A bank's total capital is calculated as a sum of its tier 1 and tier 2 capital. Regulators use the capital ratio to determine and rank a bank's capital adequacy. Tier 3 capital consists of subordinated debt to cover market risk from trading activities.