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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)

What is Tier 2 Capital?

Tier 2 Capital is a component used to calculate the capital adequacy of a bank. It includes secondary bank capital sources, such as undisclosed reserves, revaluation reserves, hybrid instruments, and subordinated debt.

How is Tier 2 Capital different from Tier 1 Capital?

Tier 1 Capital refers to the core capital of a bank, including ordinary share capital, disclosed reserves, and retained earnings. Tier 2 Capital, on the other hand, is less reliable and consists of secondary bank capital sources.

Why is Tier 2 Capital important in banking?

Tier 2 Capital is important because it serves as a buffer during financial stress. It can absorb losses, thus protecting depositors and promoting the overall stability of the banking system.

What are some examples of Tier 2 Capital?

Examples of Tier 2 Capital include undisclosable reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt.

How is Tier 2 Capital measured?

Tier 2 Capital is measured as a percentage of the total risk-weighted assets of a bank. The amount of Tier 2 Capital is typically expressed as a ratio, with a higher percentage indicating a bank’s better financial strength and lower risk exposure.

Can Tier 2 Capital be converted into Tier 1 Capital?

Some Tier 2 Capital components like hybrid instruments can be converted into Tier 1 Capital. However, it depends on the regulatory guidelines of the given jurisdiction.

What role does Tier 2 Capital play in the Basel Accords?

In the Basel Accords, which set international standards for banking regulation, Tier 2 Capital forms an integral part of the regulatory capital or capital base. This is used to ensure that banks have enough capital to meet their financial obligations and absorb unexpected losses.

If a bank has significant Tier 2 Capital, is it financially strong?

Although having significant Tier 2 Capital can add to a bank’s overall capital adequacy, Tier 1 Capital is a more reliable indicator of financial strength, due to its greater loss-absorbing capacity. A bank with high Tier 1 Capital is typically considered more financially robust.

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