Tier 1 vs. Tier 2 Capital: What’s the Difference?

Tier 1 and Tier 2 are two types of capital banks hold. Tier 1 capital is a bank’s core capital, which it uses daily. Tier 2 capital is a bank’s supplementary capital, which is held in reserve. Banks must hold certain percentages of capital on hand to help ensure the stability of the financial system. A bank’s total capital is the sum of Tier 1 and Tier 2 capital.

Key Takeaways

• Bank regulations require that Tier 1 and Tier 2 assets must be at least 10.5% of their risk-weighted assets.
• 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, subordinated term debt, general loan-loss reserves, and undisclosed reserves.

Bank Regulations

Under the Basel Accords, a bank must maintain a certain level of cash or liquid assets as a ratio of its risk-weighted assets. The Basel Accords are 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.

Note

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 the Basel Committee on Banking Supervision (BCBS).

Tier 1 Capital

Tier 1 capital consists of shareholders’ equity and retained earnings. It is a bank’s core capital and includes disclosed reserves on the bank’s financial statements. This money is used daily and is a primary indicator used to measure a bank’s financial health.

Tier 1 holds nearly all of the bank’s accumulated funds. Under Basel III, the minimum tier 1 capital ratio is 6%, which is calculated by dividing the bank’s tier 1 capital by its total risk-weighted assets (RWA). Additionally, the total capital must be at least 10.5%. RWA measures a bank’s exposure to credit risk from the loans it underwrites.

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.

Tier 2 Capital

Tier 2 capital is a bank’s supplementary capital and includes undisclosed funds that do not appear on a bank’s financial statements, revaluation reserves, hybrid capital instruments, junior debt securities, and general loan-loss or uncollected reserves.

Revalued reserves recalculate 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 equity and debt qualities, such as convertible bonds. Tier 2 capital is less reliable than Tier 1 capital and more difficult to liquidate.

Under Basel III, the minimum total capital ratio is 10.5%, and a minimum of 6% must be Tier 1 capital. Therefore, 4.5% can be Tier 2 capital if a bank has exactly 10.5% total capital. 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 10.5%.

What Does It Mean That Tier 2 Capital Is “Gone Concern?”

Tier 2 capital is a type of gone-concern capital. 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 Was 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 was abolished under the Basel III accords.

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 includes assets such as revaluation reserves, hybrid capital instruments, and undisclosed reserves. Banking regulations known as the Basel Accords require banks to hold a specific percentage of assets.