Definition
Tier 2 capital refers to components of bank capital that include subordinated debt, revaluation reserves, undisclosed reserves, and general loan-loss reserves, among others. It is viewed as less secure than Tier 1 capital—banks’ highest form of capital—because it’s more difficult to quantify and is made up of assets that are more difficult to liquidate. The ratio of Tier 2 capital to risk-weighted assets is used as a regulatory requirement for banks.
Key Takeaways
- Tier 2 Capital, also known as supplementary capital, is part of a bank’s required reserves, consisting of items such as revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated term debt.
- It’s considered less reliable than Tier 1 Capital, which is made up of more stable forms of capital such as common stock and disclosed reserves. Therefore, Tier 2 Capital is secondary to Tier 1 Capital in absorbing losses.
- Regulatory authorities scrutinize the components of both Tier 1 and Tier 2 Capital to ensure that a bank’s overall capital reserves are adequate to secure the bank’s financial stability and the safety of depositors’ funds.
Importance
Tier 2 Capital is an important term in finance as it refers to a bank’s supplementary capital, which includes undisclosed funds that may not be disclosed in the financial statements, revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and investment in non-consolidated subsidiaries.
This capital is very crucial as it is used to absorb losses in the event of a financial crisis, providing a safety net that prevents financial collapse.
It further assists in assessing a bank’s capital health and financial stability because it serves as a measure against regulatory standards, essentially ensuring the bank can handle potential economic downturns or financial struggles and keep operating smoothly.
Explanation
Tier 2 Capital, also known as secondary capital, is one of the core components of a bank’s capital and acts as a buffer against financial losses. The primary purpose of Tier 2 Capital is to absorb losses in the event of a financial distress or insolvency when Tier 1 Capital, which is deemed to be of higher quality and relatively more reliable, is completely exhausted.
Having Tier 2 Capital in place shows potential investors and regulators that the bank can sustain financial losses without collapsing, enhancing the financial stability of the institution in question. Tier 2 Capital is typically used in the calculation of a bank’s capital adequacy ratio (CAR), which is a measure of a bank’s capital as a percentage of its risk-weighted credit exposures.
This ratio is of great significance as it is regularly monitored by banking regulators to ensure that banks are holding an appropriate level of capital in order to manage the risks associated with their activities. Keeping an adequate amount of Tier 2 Capital is crucial for banks to meet the required CAR, which ultimately aids in maintaining investor confidence, ensuring regulatory compliance, and surviving in a financial crisis.
Examples of Tier 2 Capital
Subordinated Debt: In 2018, Deutsche Bank AG had Tier 2 subordinated debt which it issued to maintain its capital adequacy as per Basel III requirement. Subordinated debt generally qualify as Tier 2 capital since they have a lower priority than other debt in case of liquidation and the creditors are willing to accept a lower repayment rate in case of bankruptcy.
Revaluation Reserves: Many real estate companies and investment trusts hold significant amounts of properties. These properties usually fluctuate in value. When these properties increase in value, these companies can create revaluation reserves, which can count towards Tier 2 capital. For example, a real estate company in the UK experiencing significant property value appreciation could increase its revaluation reserves, thereby bolstering its Tier 2 capital.
Hybrid Capital Instruments: Bank of America issued hybrid capital instruments in 2020, which were qualifying as Tier 2 capital. These instruments were relatively less stable than Tier 1 capital but provided a buffer in case of financial distress. Hybrid capital instruments often come with features of both debt and equity, which makes them suitable for inclusion in Tier 2 capital.
Sure, here’s your HTML formatted FAQ section for the keyword “Tier 2 Capital”:
“`html
Frequently Asked Questions about Tier 2 Capital
What is Tier 2 Capital?
Tier 2 Capital refers to a bank’s supplementary capital. It is composed of items such as undisclosed reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt.
What is the difference between Tier 1 and Tier 2 Capital?
Tier 1 capital is a bank’s core capital, which includes equity capital and disclosed reserves. Tier 2 capital is a bank’s supplementary capital. While Tier 1 capital can absorb losses without a bank having to cease trading, Tier 2 capital can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.
Why is Tier 2 Capital important?
Tier 2 capital is important as it is a measure of a bank’s financial strength from a regulator’s point of view. It provides a safety cushion against unexpected losses and ensures the stability of a bank.
How is Tier 2 Capital calculated?
Tier 2 Capital is calculated as the sum of the following items: undisclosed reserves, revaluation reserves, general provisions & loan-loss reserves, hybrid capital instruments, subordinated term debt, and the eligible part of the bank’s net profit.
“`
Insert this code at the section of your HTML file where you would like the FAQ section to be displayed.
Related Entrepreneurship Terms
- Subordinated Debt
- Cumulative Preference Shares
- Revaluation Reserves
- General Loan-loss Reserves
- Undisclosed Reserves
Sources for More Information
- Investopedia: A comprehensive source for finance and investing explained, with lots of educational content and easy-to-understand definitions.
- The Balance: A personal finance website dedicated to helping you understand finance and make informed decisions around saving, investing, and planning.
- Corporate Finance Institute (CFI): Provides online courses and resources on finance modelling, valuation, and other financial skills, along with various financial education articles.
- Bankrate: Offers advice and tools to help you make informed decisions about your financial life, covering savings, investing, retirement, loans and insurance.
