What Was Tier 3 Capital?
Tier 3 capital consisted of low-quality, unsecured debt issued by banks before the Great Financial Crisis. Many banks held tier 3 capital to cover their market, commodities, and foreign currency risks derived from trading activities. What this really means is that banks used loans from other banks to cover any losses they took while trading on several markets.
If the markets collapsed (which they did), the banks would have to cover losses with higher-quality debt such as shareholder's equity, retained capital, or supplementary capital, draining their accounts.
Under the Basel III Accords, tier 3 capital was required to be phased out starting Jan. 1, 2013, and removed from accounts by Jan. 1, 2022.
Key Takeaways
- Tier 3 capital was unsecured debt banks held to support market risk in their trading activities.
- Unsecured, subordinated debt made up tier 3 capital and was of lower quality than tier 1 and tier 2 capital.
- The Basel Accords used to stipulate that tier 3 capital must not have been more than 2.5x a bank's tier 1 capital nor have less than a two-year maturity.
- Under the Basel III Accords, tier 3 capital was eliminated because of its contribution to the Great Financial Crisis.
Understanding Tier 3 Capital
Tier 3 capital debt used to include a greater number of subordinated issues when compared with tier 2 capital. Subordinated debt falls under other debt in payout priority if the borrower defaults. Subordinated debt is generally unsecured, meaning there is no collateral for the debt, so the issuer is left to trust that the borrower will pay them back.
Defined by the Basel II Accords, to qualify as tier 3 capital, assets must have been limited to 2.5x a bank's tier 1 capital, have been unsecured, subordinated, and have an original maturity of no less than two years.
Tier 3 Capital and the Basel Accords
Capital tiers for large financial institutions originated with the Basel Accords. These are three (Basel I, Basel II, and Basel III) agreements, which the Basel Committee on Banking Supervision (BCBS) began to roll out in 1988. In general, all of the Basel Accords provide recommendations on banking regulations concerning capital, market, and operational risks.
The goal of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. While violations of the Basel Accords bring no legal ramifications, members are responsible for implementing the accords in their home countries.
In addition to being unsecured, subordinated, and fully paid up with an original maturity of at least two years, Tier 3 capital was also required to be subject to a lock-in clause stating that interest or principal would not be paid if it caused an issuer to drop below minimum capital requirements.
Basel 1
Basel I required international banks to maintain a minimum amount (8%) of capital based on a percent of risk-weighted assets. Basel I also classified a bank's assets into five risk categories (0%, 10%, 20%, 50%, and 100%) based on the nature of the debtor (e.g., government debt, development bank debt, private-sector debt, and more).
Basel 2
In addition to minimum capital requirements, Basel II focused on regulatory supervision and market discipline. Basel II highlighted the division of eligible regulatory capital of a bank into three tiers.
Basel 3
BCBS published Basel III in 2009, following the 2008 financial crisis. Basel III was designed to improve the banking sector's ability to deal with financial stress, improve risk management, and strengthen a bank's transparency. Basel III implementation began on Jan. 1, 2013, with a 10 percentage point reduction in Tier 3 assets every year following.
Types of Tier Capital
Tier 1 capital is a bank's core capital, which consists of shareholders' equity and retained earnings; it is of the highest quality and can be liquidated quickly.
Tier 1 capital is intended to measure a bank's financial health; a bank uses tier 1 capital to absorb losses without ceasing business operations.
Tier 2 capital is supplementary capital, i.e., less reliable than tier 1 capital. A bank's total capital is calculated as a sum of its tier 1 and tier 2 capital. Regulators use the capital ratio to determine and rank a bank's capital adequacy.
Tier 2 capital includes revaluation reserves, hybrid capital instruments, and subordinated debt. In addition, tier 2 capital incorporates general loan-loss reserves and undisclosed reserves.
Tier 3 capital consisted of subordinated debt to cover market risk from trading activities, but it is now not used in the banks of Basel Accord member countries.
How Much Tier 3 Can a Bank Hold?
Tier 3 accounts are no longer used in Basel Accord member countries.
What Is Tier 3 Debt?
Tier 3 debt was unsecured and subordinated debt. This would have been any instrument a bank issued as a loan without requiring collateral, which was lower in priority than other debts.
What Is the Meaning of Tier 3 Account?
A Tier 3 account is a retail industry term for a target account or an account a business would like to create for an ideal customer.
The Bottom Line
Tier 3 capital used to be common in banking as a way to reduce the risks associated with trading, but it was phased out in 2013 by Basel Accord member countries. This type of capital was associated with contributing to the Great Financial Crisis because it was debt used to cover losses from investments and trading. When large investment and other banks began to fail during the Great Financial Crisis, they didn't have the capital to cover the losses because their backup plan was to use the debt as an emergency fund.
