Following from the capital adequacy requirements under the Basel III accord, banks’ capital was split into tier 1 and tier 2 capital. Tier 1 forms the bank’s core capital, while Tier 2 forms its supplementary capital. The instruments under Tier 2 capital are riskier as it is difficult to assess their quality and they are harder to liquidate. However, the purpose of tier 1 and tier 2 capital is to ensure that banks can absorb losses (if any) and continue functioning under periods of financial duress.
Tier 2 Capital:
In India, tier 2 capital consists of reserves and hybrid securities. Reserves are capital provisions that a bank makes. Hybrid securities carry features of both debt and equity instruments and may further be classified into upper (perpetual instruments) and lower capital (dated instruments).
General Provisions & Loss Reserves:
This reserve is created as a hedge against any unidentified losses.
A revaluation reserve is created by reassessing the value of an asset. The idea is to update the value of an asset from its historic cost to its current value. For instance, a bank may have one of its properties revalued to reflect appreciation in real estate.
Primarily this consists of perpetual cumulative preference shares (PCPS). Like AT1 instruments, these securities have no maturity. A cumulative instrument is one where payments if missed, are accrued and paid when finances permit.
Dated securities are those that have a maturity. Tier 2 Capital instruments are redeemable and may be cumulative or non-cumulative preference shares (RCPS or RNCPS). These instruments have a minimum tenor of 5 years.
As banking systems in multiple countries evolved,the need to have an international agreement that bound them arose. The idea was to addresses regulation, supervision, and risk management for banks across the globe. The Basel Committee on Bank Supervision was set up in 1974 to create a framework.
Basel I & Basel II Norms
Every loan has an associated level of risk. Credit risk is the possibility that a borrower may not meet its obligations. Based on this, a risk value was assigned to each loan, making it a Risk Weighted Asset (RWA). Capital provisions were set according to the RWA.
Basel II norms further focused on three pillars.
Pillar 1: Minimal Capital
‘Risk’ was modified to include market and operational risks. Minimal capital requirements for lending transactions was specified as 8% of RWAs. Banks’ capital was tiered according to its nature.
Pillar 2: Supervisor Review
Banking regulations varied drastically across member countries. However, the requirement for improved governance and regulation remained. The solution was to authorize the banking regulator of each country to implement these rules. In India, the RBI is the regulator for the banking sector.
Pillar 3: Market Discipline
Market Discipline simply means more transparency. Banks were subjected to more disclosure requirements. This provided more insight into their activities and allowed for more informed investment decisions.
Why did we need Basel III norms?
While the earlier norms addressed legitimate risks, gaps became apparent during the 2007 financial crisis. Any framework is robust only when it is modified to address new challenges and risks.
The focus moved to banks’ balance sheets. It aimed to reduce their size and limited the scope of activities. Both quality and quantity of capital became important. The spotlight shifted to lowering risk rather than increasing profitability.
New metrics for risk management such as the liquidity coverage ratio (LCR)and leverage ratio were introduced. Banks are also subjected to standardized stress tests. This ensures that there is sufficient liquidity for banks to proceed with day-to-day activities during periods of financial stress. The capital requirements are adjusted according to prevailing market conditions. This move protects the economy during both recessions and booms.
Ultimately, the intent is to create a more resilient banking system by reducing and addressing potential financial or economic risks.