Tier 1 and tier 2 capital are two types of assets held by banks. Tier 1 capital is a bank's core capital, which it uses to function on a daily basis. Tier 2 capital is a bank's supplementary capital, which is held in reserve.
Banks must hold certain percentages of different types of capital on hand. Having these types of liquid assets or cash on hand balances out the risk-weighted assets that banks hold. This increases the stability of the financial system.
Key Takeaways
- Under Basel III, a bank's tier 1 and tier 2 assets must be at least 10.5% of its risk-weighted assets, up from 8% under Basel II.
- Tier 1 capital is the primary funding source of the bank and consists of shareholders' equity and retained earnings.
- Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves.
- Tier 2 capital is considered less reliable than tier 1 capital because it is more difficult to accurately calculate and more difficult to liquidate.
Why Are Different Types of Capital Important?
Under the Basel Accords, a bank has to maintain a certain level of cash or liquid assets as a ratio of its risk-weighted assets. The Basel Accords are a series of three sets of banking regulations that help to ensure financial institutions have enough capital on hand to handle obligations.
The Accords set the capital adequacy ratio (CAR) to define these holdings for banks. Under Basel III, a bank's tier 1 and tier 2 assets must be at least 10.5% of its risk-weighted assets. Basel III increased the requirements from 8% under Basel II.
Tier 1 Capital vs. Tier 2 Capital: An Overview
A bank's capital consists of tier 1 capital and tier 2 capital. These two primary types of capital reserves are different in several respects.
- Tier 1 capital is a bank's core capital and includes disclosed reserves—that appear on the bank's financial statements—and equity capital. This money is the funds a bank uses to function on a regular basis and forms the basis of a financial institution's strength.
- Tier 2 capital is a bank's supplementary capital. Undisclosed reserves, subordinated term debts, hybrid financial products, and other items make up these funds.
A bank's total capital is calculated by adding its tier 1 and tier 2 capital together. Regulators use the capital ratio to determine and rank a bank's capital adequacy.
There was formerly a third type of capital called tier 3 capital.
Tier 1 Capital
Tier 1 capital consists of shareholders' equity and retained earnings, which are disclosed on their financial statements. It is a primary indicator used to measure a bank's financial health.
Tier 1 capital is the primary funding source of the bank. Typically, it holds nearly all of the bank's accumulated funds. These funds are generated specifically to support banks when losses are absorbed so that regular business functions do not have to be shut down.
Under Basel III, the minimum tier 1 capital ratio is 10.5%, which is calculated by dividing the bank's tier 1 capital by its total risk-weighted assets (RWA). RWA measures a bank's exposure to credit risk from the loans it underwrites.
For example, assume a financial institution has US$200 billion in total tier 1 assets. If they have a risk-weighted asset value of $1.2 trillion, the capital ratio is 16.66%:
($200 billion / $1.2 trillion)*100=16.66%
This is well above the Basel III requirements.
There are further requirements on sources of the tier 1 funds. This ensures that the funds are sufficiently liquid and are available when the bank needs to use them.
Tier 2 Capital
Tier 2 capital includes:
- Undisclosed funds that do not appear on a bank's financial statements
- Revaluation reserves
- Hybrid capital instruments
- Subordinated term debt, also known as junior debt securities
- General loan-loss, or uncollected, reserves
Revalued reserves is an accounting method that recalculates the current value of a holding that is higher than what it was originally recorded as, such as with real estate. Hybrid capital instruments are securities that have both equity and debt qualities, such as convertible bonds.
Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital. It is more difficult to accurately measure due because it is composed of assets that are difficult to liquidate. Often banks will split these funds into upper- and lower-level pools depending on the characteristics of the individual asset.
Under Basel III, the minimum total capital ratio is 12.9%, which indicates the minimum tier 2 capital ratio is 2%, as opposed to 10.9% for the tier 1 capital ratio.
If the bank from the example above reported tier 2 capital of $30 billion, its tier 2 capital ratio for the quarter would be 2.5%:
($30 billion/$1.2 trillion)*100 = 2.5%
Thus, its total capital ratio was 19.16% (16.66% + 2.5%). Under Basel III, the bank met the minimum total capital ratio of 12.9%.
Tier 3 Capital
Previously the tiers of capital included a third layer. Tier 3 capital is tertiary capital, which many banks hold to support their market risk, commodities risk, and foreign currency risk, derived from trading activities. Tier 3 capital includes a greater variety of debt than tier 1 and tier 2 capital but is of a much lower quality than either of the two. Under the Basel III accords, tier 3 capital is being completely abolished.
What Does It Mean That Tier 2 Capital Is Gone Concern?
Tier 2 capital is a type of gone-concern capital. This means that, if a bank fails, its tier 2 assets will absorb any losses before its creditors or depositors do.
What Does a High Tier 1 Capital Ratio Mean?
A bank's tier 1 capital ratio compares its core equity assets to its risk-weighted assets. A high ratio means that the bank has enough liquid assets on hand and is more likely to absorb losses without the risk of a bank failure.
What Do the Basel Accords Do?
The Basel Accords are international banking regulations that ensure banks have enough capital on hand both to meet their obligations and absorb any unexpected losses. They are set by theBasel Committee on Bank Supervision (BCBS).
The Bottom Line
Tier 1 capital is the primary funding source of a bank. It consists of shareholders' equity and retained earnings.Tier 2 capital is less liquid and harder to measure accurately. It includes assets such as revaluation reserves, hybrid capital instruments, and undisclosed reserves.
Banking regulations known as the Basel Accords require banks to have different types of capital on hand. These liquid and cash assets balance out the risk-weighted assets that banks hold. This increases banks' stability, which increases the stability of the overall financial system.
