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. Tier 3 capital includes a greater variety of debt than tier 1 and tier 2 capitals (see below).
Breaking Down Tier 3 Capital
Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves as compared with tier 2 capital. To qualify as tier 3 capital, assets must be limited to 250% of a banks tier 1 capital, be unsecured, subordinated, and have a minimum maturity of two years.
The Origin of Tier 3 Capital
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 Bank 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 sought to improve the banking sector's ability to deal with financial stress, improve risk management, and strengthen banks' transparency.
Tier 1 Capital, Tier 2 Capital, Tier 3 Capital
Tier 1 capital is a bank's core capital, which consists of shareholders' equity and retained earnings; while Tier 2 capital includes revaluation reserves, hybrid capital instruments, and subordinated term 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 (e.g., less reliable than tier 1 capital.)
Tier 3 capital consists of Tier 2 capital plus short-term subordinated loans.