Tier 2 Capital: Definition, 4 Components, and What They Include

What Is Tier 2 Capital?

The term tier 2 capital refers to one of the components of a bank's required reserves. Tier 2 is designated as the second or supplementary layer of a bank's capital and is composed of items such as revaluation reserves, hybrid instruments, and subordinated term debt. It is considered less secure than Tier 1 capital—the other form of a bank's capital—because it's more difficult to liquidate. In the United States, the overall capital requirement is partially based on the weighted risk of a bank's assets.

Understanding Tier 2 Capital

Bank capital requirements were designated as part of the international Basel Accords. This set of recommendations was developed by the Basel Committee on Bank Supervision over a number of years dating back to the 1980s. According to the regulations, banks must maintain a certain amount of cash and/or other forms of liquid assets on hand in order to meet their obligations. No more than 25% of a bank's capital requirements can be comprised of Tier 2 capital.

Bank capital is divided into two layers—Tier 1 or core capital and Tier 2 or supplementary capital. A bank's capital ratio is calculated by dividing its capital by its total risk-based assets. The minimum capital ratio reserve requirement for a bank is set at 8%—6% of which must be provided by Tier 1 capital. The remaining must be Tier 2 capital. Along with Tier 1 capital, it provides a bank with a financial cushion in case it needs to liquidate its assets.

There are four components of Tier 2 capital. These include:

• Revaluation reserves: These are reserves created by the revaluation of an asset. A typical revaluation reserve is a building owned by a bank. Over time, the value of the real estate asset tends to increase and can thus be revalued.
• General provisions: This category consists of losses that a bank may have of an as yet undetermined amount including from loans. The total general provision amount allowed is 1.25% of the bank's risk-weighted assets (RWA).
• Hybrid capital instruments: This type of capital is a mixture of both debt and equity instruments. Preferred stock is an example of a hybrid instrument. A bank may include hybrid instruments in its Tier 2 capital as long as the assets are sufficiently similar to equity so losses can be taken on the face value of the instrument without triggering the liquidation of the bank.
• Subordinated debt: Debt is subordinated in regard to ordinary bank depositors and other loans and securities that constitute higher-ranking senior debt. The minimum original term of this debt is over five years.

Tier 2 capital is split into upper and lower levels. Upper-level Tier 2 capital consists of securities that are perpetual—meaning they have no maturity date—revaluation reserves, and fixed asset investments. Lower-level Tier 2 capital consists of subordinated debt and is generally inexpensive for a bank to issue.

Special Considerations

Undisclosed reserves may be counted as part of a bank's Tier 2 capital in certain countries. These reserves are profits a bank earns that don't appear on publicly-available documents such as a bank's balance sheet. Despite not being disclosed, most banks still consider these reserves to be real assets.

Regulatory authorities in some countries recognize their banks' undisclosed reserves as part of Tier 2 capital. Most countries, including the United States, do not allow this kind of capital to be used to legitimately meet reserve requirements.

Tier 2 Capital vs. Tier 1 Capital

As mentioned above, a bank's capital reserves are divided into tiers. Unlike Tier 2 capital, Tier 1 capital is a bank's core capital or the primary source of funding for a bank. As such, it consists of almost all of an institution's funds including all of its disclosed reserves and any equity capital like common stock. This capital helps a bank absorb any losses so it can continue its day-to-day operations. Because this level is composed of a bank's core capital, Tier 1 is a very good indicator of its financial health. This tier is considered more reliable than Tier 2 capital. That's because the capital is much easier to calculate accurately. The assets that fall into this category are also much easier to liquidate.

The Bottom Line

Banking regulations known as the Basel Accords require banks to hold different types of capital on hand and certain percentages of each. Having these types of liquid assets or cash balances out the risk-weighted assets that banks hold and increases the stability of the financial system.

Tier 2 capital is the supplementary capital held in reserve by a bank. It is less reliable than tier 1 capital because it's composed of assets that are difficult to liquidate, and it's more difficult to measure accurately.