Tier 2 Capital

Definition

Tier 2 capital, also known as supplementary capital, is a component of the bank’s capital measured by banking regulators. This capital includes undisclosed reserves, revaluation reserves, subordinated term debt, and hybrid securities. It is considered to be a less reliable form of capital than Tier 1 capital, which is composed of more liquid assets.

Phonetic

The phonetics of the keyword “Tier 2 Capital” is: “Teer Too Kap-iht-l”.

Key Takeaways

Sure, here are three main takeaways about Tier 2 Capital in HTML numbered form.“`

1. Tier 2 Capital, also known as supplementary capital, is one of the components of bank’s capital. This includes items such as undisclosed reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt.
2. Compared to Tier 1 Capital which are core capital, including equity capital and disclosed reserves, Tier 2 Capital is considered less reliable. It is used to absorb losses if the bank becomes insolvent.
3. The adequate amount of Tier 2 Capital a bank must hold is determined by the Basel III Accord on bank regulation. Under the new Basel III framework, the minimum Tier 2 capital ratio is 2.0%.

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Importance

Tier 2 Capital is an important term in business and finance as it refers to a bank’s supplementary capital and is one of the aspects of the banking regulatory framework under Basel III. This category includes revaluation reserves, undisclosed reserves, hybrid instruments, and subordinated term debt. It is less secure compared to tier 1 capital, which consists of more liquid assets. Importance of Tier 2 capital lies in its capability to absorb losses in the event of a winding-up, hence providing a measure of protection to depositors and senior creditors. It’s the secondary component of a bank’s capital and is considered less reliable than Tier 1 capital in the event of a financial strain or crisis. It provides an additional layer of security, if the bank suffers financial loss. Therefore, understanding Tier 2 capital is key to assessing a bank’s overall health and resilience in the face of financial stress.

Explanation

The main purpose of Tier 2 Capital, also referred to as supplementary capital, is to support a bank’s operations and growth by providing a secondary, safety net layer of capital. This type of capital forms a part of the bank’s capital base and acts as a buffer during times of financial distress or operational risk. The more capital a bank has, the better it can withstand losses. Therefore, Tier 2 Capital aids the stability of a financial institution while protecting its investors and customers from potential losses.The usage of Tier 2 Capital becomes significantly critical when a bank finds itself in a troubled financial situation. If an institution’s Tier 1 Capital, which is its core capital, is unable to cover the losses, then the bank will start consuming its Tier 2 Capital. In essence, Tier 2 Capital can be used by banks to sustain losses without ceasing their trading operations. Therefore, in a broad sense, it helps in maintaining a stable, secure, and efficiently functioning banking system.

Examples

1. Subordinated Debt: In 2013, JP Morgan, a leading financial institution, issued subordinated debt that qualifies as Tier 2 capital. The move was designed to enhance the company’s Tier 2 ratio, which is a key measure of financial strength and stability. The subordinated debt carries a higher risk compared to other forms of debt, as it’s paid only after other forms of debt in the event of a company’s liquidation, hence it falls under Tier 2 capital.2. Revaluation Reserves: In 2017, several UK banks revalued their property portfolios, leading to a large increase in the value of the properties they owned. This revaluation reserve is considered part of Tier 2 capital, as it provides an additional layer of capitalisation, even though it’s not as reliable as Tier 1 capital (shares and retained earnings). 3. General Loan-loss Reserves: As part of their Tier 2 capital, banks such as Wells Fargo and Bank of America often maintain general loan-loss reserves. These reserves are set aside as capital to cover potential losses from bad loans, offering a buffer to absorb losses and protect depositors and creditors. It is not necessarily linked to any specific loans, but is ready to cover unanticipated losses, making these reserves part of Tier 2 capital.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Subordinated Debt
• Loan Loss Reserves
• Revaluation Reserves
• Undisclosed Reserves
• Hybrid (debt/equity) Capital Instruments

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Wall Street Mojo
• The Balance