Tier 2 Capital

Tier 2 capital is the supplementary layer of a bank's regulatory capital. It consists mainly of long-dated subordinated debt and, within limits, certain reserves held against loan losses. Its purpose is to absorb losses once a bank has failed or is close to failing, protecting depositors and senior creditors, which is why it is described as gone-concern capital.

It ranks below Tier 1 capital in quality. Tier 1, made up of Common Equity Tier 1 (CET1) and Additional Tier 1 capital (AT1), absorbs losses while the bank continues to operate. Tier 2 instruments have a fixed maturity and pay contractual interest, so they cannot cushion losses in the same way, but they stand ahead of ordinary creditors in taking losses at failure. The definition is set internationally by the Basel Committee on Banking Supervision and applied through national rules.

Under Basel III, Tier 2 has two main components. The first is capital instruments issued by the bank that meet the eligibility criteria, together with any related share premium. In practice these are subordinated bonds and loans, usually with an original term of ten years and often with an issuer call option after five.

The second is loss reserves. A bank using the standardised approach for credit risk may include general provisions, held against losses not yet identified on specific loans, up to 1.25% of its credit risk-weighted assets. A bank using the internal ratings-based approach may include any excess of its eligible provisions over expected losses, up to 0.6% of the risk-weighted assets calculated under that approach. Regulatory deductions, for example for holdings of other banks' Tier 2 instruments, are then applied.

To qualify, an instrument must meet conditions designed to ensure that it is genuinely available to absorb losses:

• Subordination. Claims rank below depositors and general creditors in a winding-up.
• Maturity. The original maturity must be at least five years, and there must be no step-up in the coupon or other incentive to redeem early.
• Amortisation. Recognition in regulatory capital is reduced on a straight-line basis during the final five years to maturity, so a bond with three years left counts for only part of its face value.
• Calls. The issuer may call the instrument only after at least five years, only with the supervisor's prior approval, and must not create an expectation that it will do so.
• No acceleration. Investors have no right to demand early repayment of future interest or principal except in bankruptcy or liquidation.
• No support. The instrument is paid in, is not secured or guaranteed by the bank or a related entity, and was not funded by the bank itself.
• Loss absorption at non-viability. The instrument must be capable of being written down or converted into ordinary shares when the authorities decide the bank is no longer viable, either under its contractual terms or under a statutory resolution regime.

Basel III requires banks to hold CET1 of at least 4.5% of risk-weighted assets, Tier 1 capital of at least 6% and total capital of at least 8%. The gap of two percentage points between the Tier 1 and total requirements is the part that Tier 2 can fill, though a bank may meet it with higher-quality capital instead. The combined measure is the total capital ratio. Capital buffers such as the capital conservation buffer sit on top of these minimums and must be met with CET1 alone.

Tier 2 debt also counts towards loss-absorbing capacity requirements for resolution, including total loss-absorbing capacity for the largest global banks and its European counterpart, the minimum requirement for own funds and eligible liabilities. In a bail-in, Tier 2 holders take losses after shareholders and AT1 investors and before senior creditors.

The 1988 Basel Accord introduced the two-tier structure and allowed a wide range of items in Tier 2, including revaluation reserves, hybrid instruments and subordinated term debt, subdivided into upper and lower Tier 2. A third tier of short-term subordinated debt was later permitted to cover market risk. During the 2008 financial crisis, many holders of Tier 2 instruments in rescued banks suffered no loss because governments injected public funds before the banks entered insolvency, so the capital did not perform its intended function.

Basel III responded by simplifying Tier 2 into a single category, abolishing Tier 3, tightening the criteria and adding the point of non-viability requirement. Older instruments that did not meet the new standard were phased out of regulatory capital over a transitional period.

For investors, Tier 2 bonds offer a higher yield than a bank's senior debt in exchange for greater loss in failure, and typically carry a lower credit rating than the issuer's senior bonds. For banks they are cheaper than equity, and the interest is generally tax-deductible.

The main limitation is that Tier 2 helps only at the end of a bank's life. It does not prevent failure, and its usefulness depends on authorities being willing and able to impose losses on bondholders. The reducing recognition in the last five years also means banks must refinance regularly, exposing them to market conditions at the time of issue.

• Bank for International Settlements: The Basel Framework