Tier 2 capital is an important element that bank regulators use to determine a bank’s total capital base.
It is seen as less reliable than Tier 1 capital – another element used to determine a bank’s capital base.
Tier 2 capital was defined by the Basel Committee on Banking Supervision (BCBS) in the Basel Accords – a set of international banking recommendations. The Basel Committee on Banking Supervision is a forum that cooperates on banking supervisory matters. Its aim is to improve understanding of key supervisory issues and enhance the quality of banking oversight globally.
When calculating regulatory capital, Tier 2 is limited to 100 percent of Tier 1 capital.
There are two sub-categories of Tier 2 capital: Upper and Lower.
Upper Tier 2 capital consists of:
- subordinated debt
- perpetual securities with step up and call features or other incentives to redeem
- revaluation reserves from fixed assets
- fixed asset investments
Lower Tier 2 capital consists of dated subordinated debt. According to the Basel Accords, Lower Tier 2 cannot make up more than a quarter of a bank’s total capital.
Using Tier 2 Capital to determine a bank’s solvency
Tier 2 capital is used to determine a bank’s capital adequacy ratio (CAR) – a measure of a bank’s ability to absorb losses.
CAR is calculated by using the following formula:
(Tier 1 capital + Tier 2 capital) ÷ (Risk weighted assets) = CAR
“Tier 1 capital is core capital that is relatively transparent and secure (comprising equity capital and disclosed reserves), while tier 2 capital is supplementary capital that is more complex and variable (such as loan loss provisions and subordinated debt).”