Basel III Tier 2 Capital
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.
Capital raised under Tier 1 and Tier 2 requirements are riskier than standard debt instruments. They are not equivalent to a fixed deposit or equity shares. These issues are not backed by any assets and are not covered by any guarantee. Their loss absorption features are intended to protect the bank. Therefore, these instruments are suitable only for investors whose risk capacity is high.