Tier 2 capital

What Is Tier 2 Capital?

Tier 2 capital is a component of a bank's regulatory capital, serving as supplementary capital that can absorb losses in the event of a bank's failure. It is part of the broader framework of capital requirements within banking regulation, designed to ensure financial stability and protect depositors. While considered less robust than Tier 1 capital, Tier 2 capital plays a crucial role by providing an additional layer of protection, particularly in a "gone concern" scenario where a bank is nearing insolvency. This type of capital is structured to absorb losses only after core Tier 1 capital has been depleted.⁵¹

History and Origin

The concept of bank capital requirements, including the differentiation of capital into tiers, has evolved significantly over centuries, often in response to financial crises. Early forms of capital adequacy were determined by rules of thumb.⁵⁰ However, the formalization of global banking capital standards began with the Basel Accords.⁴⁸, ⁴⁹ The first Basel Accord (Basel I), introduced in 1988 by the Basel Committee on Banking Supervision (BCBS), marked a historic international agreement to standardize bank capital requirements worldwide.⁴⁶, ⁴⁷ It established a framework that categorized assets by risk and defined what instruments could count as "capital," including initial definitions for Tier 1 and Tier 2 capital.⁴³, ⁴⁴, ⁴⁵

The need for more stringent and precise capital definitions became starkly apparent during the 2007-2009 global financial crisis.⁴² In response, the BCBS developed Basel III, a comprehensive set of reforms published in December 2010.⁴⁰, ⁴¹ Basel III aimed to strengthen the quality and quantity of bank capital, introducing a clearer distinction between "going concern" capital (Tier 1) and "gone concern" capital (Tier 2), and mandating that all capital instruments be capable of fully absorbing losses at the point of non-viability.³⁹ These updated standards have significantly influenced how financial institutions structure their balance sheets and manage risk.

Key Takeaways

Tier 2 capital is supplementary capital held by banks to absorb losses, particularly if a bank is facing liquidation.
It consists of instruments like subordinated debt, hybrid capital instruments, and certain reserves.³⁸
Tier 2 capital provides an additional layer of protection beyond Tier 1 capital, enhancing a bank's overall bank solvency.³⁶, ³⁷
Its characteristics mean it absorbs losses in a "gone concern" scenario, where a bank is failing, before depositors and general creditors incur losses.³⁵
Regulatory bodies, such as the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), define the specific criteria for instruments to qualify as Tier 2 capital.³³, ³⁴

Formula and Calculation

Tier 2 capital itself is a sum of eligible components rather than derived from a single formula. However, it forms a crucial part of a bank's total regulatory capital, which is then used to calculate various capital ratios. For instance, the Total Capital Ratio is a key metric that assesses a bank's capital adequacy relative to its risk-weighted assets (RWA).³⁰, ³¹, ³²

The general structure of total capital is:

\text{Total Capital} = \text{Tier 1 Capital} + \text{Tier 2 Capital}

The Total Capital Ratio is then calculated as:

\text{Total Capital Ratio} = \frac{\text{Tier 1 Capital} + \text{Tier 2 Capital}}{\text{Risk-Weighted Assets}}

Where:

Tier 1 Capital: Primarily includes common equity and retained earnings.
Tier 2 Capital: Comprises supplementary instruments such as subordinated debt, hybrid instruments, and general loan-loss reserves (up to certain limits).²⁹
Risk-Weighted Assets (RWA): A bank's assets weighted according to their credit risk, market risk, and operational risk.²⁸

Under Basel III, a bank's total capital ratio, including both Tier 1 and Tier 2 capital, must generally be at least 8% of its risk-weighted assets.²⁶, ²⁷ However, the amount of Tier 2 capital that can be included in total capital is typically limited to 100% of Tier 1 capital.²⁵

Interpreting Tier 2 Capital

Tier 2 capital is interpreted as the secondary line of defense against financial distress for a bank. Unlike Tier 1 capital, which is designed to absorb losses while the bank remains a going concern, Tier 2 capital is structured to absorb losses at the point of non-viability or during a resolution process.²⁴ Its presence indicates an additional buffer that can protect depositors and senior creditors in extreme scenarios, bolstering overall bank solvency.²³

Regulators closely monitor the composition and quantity of Tier 2 capital as part of a bank's overall capital adequacy framework. A healthy amount of Tier 2 capital, in conjunction with robust Tier 1 capital, signals a bank's resilience to unexpected shocks and its capacity to sustain losses without immediately jeopardizing its operations or requiring taxpayer bailouts. Investors and analysts also consider Tier 2 capital when assessing a bank's financial strength and its ability to withstand adverse economic conditions.

Hypothetical Example

Consider "Horizon Bank," a hypothetical financial institution, with the following simplified capital structure:

Common Equity Tier 1 (CET1) Capital: $800 million
Additional Tier 1 (AT1) Capital: $200 million
Eligible Subordinated Debt (Tier 2): $300 million
General Loan-Loss Reserves (eligible for Tier 2): $50 million
Risk-Weighted Assets (RWA): $10,000 million (or $10 billion)

First, we calculate Tier 1 Capital:

\text{Tier 1 Capital} = \text{CET1 Capital} + \text{AT1 Capital}

\text{Tier 1 Capital} = \$800 \text{ million} + \$200 \text{ million} = \$1,000 \text{ million}

Next, we determine Tier 2 Capital. Assuming all the subordinated debt and general loan-loss reserves meet regulatory criteria for inclusion as Tier 2 capital:

\text{Tier 2 Capital} = \text{Eligible Subordinated Debt} + \text{Eligible General Loan-Loss Reserves}

\text{Tier 2 Capital} = \$300 \text{ million} + \$50 \text{ million} = \$350 \text{ million}

Now, we calculate the Total Capital Ratio, which includes both Tier 1 and Tier 2 capital relative to the bank's risk-weighted assets:

\text{Total Capital Ratio} = \frac{\text{Tier 1 Capital} + \text{Tier 2 Capital}}{\text{Risk-Weighted Assets}}

\text{Total Capital Ratio} = \frac{\$1,000 \text{ million} + \$350 \text{ million}}{\$10,000 \text{ million}} = \frac{\$1,350 \text{ million}}{\$10,000 \text{ million}} = 0.135 \text{ or } 13.5\%

In this example, Horizon Bank's Total Capital Ratio of 13.5% exceeds the typical minimum regulatory requirement of 8%, demonstrating a sound capital position. This healthy ratio means Horizon Bank has a substantial buffer against potential losses, protecting its stability and its depositors.

Practical Applications

Tier 2 capital is fundamentally applied in the realm of banking regulation and risk management. Regulators like the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve require banks to hold minimum amounts of Tier 2 capital as part of their overall capital adequacy framework.²¹, ²² This ensures that banks maintain a robust financial cushion against unexpected losses, which is critical for financial stability.²⁰

Beyond regulatory compliance, Tier 2 capital instruments, particularly subordinated debt, are used by banks as a funding source.¹⁹ Issuing subordinated debt allows banks to raise long-term capital without diluting existing equity shareholders, providing a more stable funding base than short-term liabilities.¹⁸ Investors often analyze a bank's Tier 2 capital composition when evaluating its creditworthiness and resilience to economic downturns, understanding that these instruments offer a yield in exchange for their subordinated status. The guidelines for issuing subordinated debt that qualifies as regulatory capital are detailed by regulators such as the Office of the Comptroller of the Currency (OCC).¹⁶, ¹⁷

Limitations and Criticisms

Despite its role in bolstering bank capital, Tier 2 capital has several limitations and faces criticisms. One primary critique is that, by its very nature, Tier 2 capital provides a less immediate and less robust form of loss absorption compared to common equity Tier 1 capital. It is considered "gone-concern" capital, meaning it is intended to absorb losses primarily when a bank is nearing insolvency or during a resolution process, rather than acting as a buffer for ongoing operations.¹⁵

The complexity of some Tier 2 instruments, such as certain hybrid instruments or contingent convertible bonds, can also make their loss-absorbing capacity less transparent or reliable under stress.¹⁴ Critics argue that the reliance on such instruments, as opposed to pure equity, can mask underlying vulnerabilities in a bank's capital structure.¹³ Furthermore, the specific rules for what qualifies as Tier 2 capital and how it is treated in different jurisdictions can vary, potentially leading to inconsistencies in international capital adequacy assessments.¹² While regulators aim to create a stable financial system, some economists contend that the current capital adequacy approaches, despite their complexity, may not fully address the fundamental causes of bank failures, particularly during severe market disruptions.¹¹

Tier 2 Capital vs. Tier 1 Capital

Tier 2 capital and Tier 1 capital are both crucial components of a bank's regulatory capital, but they differ significantly in their quality, permanence, and ability to absorb losses.

Tier 1 Capital is considered a bank's core capital, representing its highest quality and most permanent form of capital. It primarily consists of common equity (like common stock and retained earnings) and certain disclosed reserves. Tier 1 capital is designed to absorb losses while the bank is still a going concern, allowing it to continue operating during periods of financial stress. It is readily available to cushion losses immediately and does not require the bank to cease operations to absorb them.¹⁰

Tier 2 Capital, on the other hand, is supplementary capital that provides an additional layer of protection but is generally of lower quality and less permanent than Tier 1 capital. It includes instruments such as subordinated debt, hybrid capital instruments (which blend characteristics of both debt and equity), and certain general provisions against loan losses.⁹ The key distinction is that Tier 2 capital is considered "gone-concern" capital; it is primarily intended to absorb losses in the event of liquidation or resolution of the bank. While it enhances overall capital adequacy, it does so in a scenario where the bank's ability to operate independently is already severely compromised.⁸ The terms of Tier 2 instruments often stipulate that they can absorb losses before depositors and general creditors, but after Tier 1 capital.

FAQs

What types of instruments typically make up Tier 2 capital?

Tier 2 capital generally includes subordinated debt, which ranks below other debts in the event of liquidation; hybrid instruments that possess characteristics of both debt and equity; and certain revaluation reserves and general loan-loss reserves.⁷

Why is Tier 2 capital considered less secure than Tier 1 capital?

Tier 2 capital is considered less secure because its components are generally more difficult to liquidate or are less permanent than those of Tier 1 capital. It is designed to absorb losses in a "gone concern" scenario, meaning when a bank is facing failure, whereas Tier 1 capital absorbs losses while the bank is still operating.⁶

How do international standards like Basel III affect Tier 2 capital requirements?

Basel III, an international regulatory framework, sets minimum requirements for Tier 2 capital as part of a bank's total capital ratio.⁵ It also introduced stricter criteria for instruments to qualify as Tier 2, ensuring they genuinely provide loss-absorbing capacity at the point of non-viability to enhance overall financial stability.⁴

Does Tier 2 capital protect individual depositors directly?

While Tier 2 capital provides an additional layer of loss absorption, its primary role is to protect the bank's solvency and, by extension, the financial system. For individual depositors in many countries, deposit insurance schemes, such as those provided by the FDIC in the U.S., offer direct protection for their deposits up to certain limits.³ Tier 2 capital helps ensure that a bank has sufficient internal resources to absorb losses before deposit insurance funds are significantly impacted.

Can a bank choose not to hold Tier 2 capital?

No, banks are typically required by regulatory bodies to maintain certain minimum levels of both Tier 1 and Tier 2 capital, as part of their overall capital adequacy requirements. These requirements are set to ensure the safety and soundness of the banking system.¹, ²