Tier 2 Capital

Reviewed by Sweta | Updated on Sep 30, 2020

Introduction

Tier 2 capital is a component of the bank capital. It consists of the bank's supplementary capital including undisclosed reserves, revaluation reserves, and subordinate debt. Tier 2 capital is less secure than Tier 1 capital.

What is Tier 2 Capital?

The norms for Tier 1 and Tier 2 capital are specified in the banking regulations made by the Basel Committee on Bank Supervision. The norms are prescribed to ensure that banks are adequately capitalised.

Tier 2 capital is the secondary component of bank capital. The capital requirements are governed by international banking regulations set under Basel norms.

Further About Tier 2 Capital

The capital reserve ratio for a bank is prescribed at 8%. It stands at 6% for Tier 1 capital and the balance 2% for Tier 2 capital. Usually, a bank's capital ratio is calculated by dividing its capital by its total risk-based assets.

Tier 2 capital consists of 2 sub-categories:

Upper Tier 2 Capital: It consists of fixed asset investments, revaluation reserves, and perpetual securities.

Lower Tier 2 Capital: It consists of subordinated debt with a minimum of five-year maturity.

Tier 2 capital also consists of hybrid capital instruments, which have the character of both equity and debt. It is characterised by being inexpensive for a bank to issue, with coupons that are not deferrable without triggering a default.

Tier 2 capital is variable and supplementary in nature compared to Tier 1 capital which is the core capital of the bank.

Revaluation reserves are reserves created upon the revaluation of an asset. A typical revaluation reserve is like a building owned by a bank. With passing time, the value of the real estate asset tends to increase whose value is captured upon revaluation of the asset.

Hybrid instruments may be part of the Tier 2 capital as long as the assets are sufficiently similar to equity and do not trigger a liquidation of the bank.

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