# Understanding Tier 2 Capital: Key Components & Financial Impact

## What Is Tier 2 Capital?

The term tier 2 capital refers to one of the components of a bank's required reserves. Tier 2 is designated as the second or supplementary layer of a bank's capital and is composed of items such as revaluation reserves, hybrid instruments, and subordinated term debt. It is considered less secure than [Tier 1 capital](https://www.investopedia.com/terms/t/tier1capital.asp)—the other form of a bank's capital—because it's more difficult to [liquidate](https://www.investopedia.com/terms/l/liquidate.asp). In the United States, the overall capital requirement is partially based on the weighted risk of a bank's assets.

### Key Takeaways

*   Tier 2 capital is a bank's supplementary reserve, including revaluation reserves, hybrid instruments, and subordinated term debt.  
    
*   Banks must maintain a minimum capital ratio of 8%, with at least 6% from Tier 1 capital.  
    
*   Undisclosed reserves, while real, are mostly not accepted in Tier 2 capital calculations in the U.S.  
    
*   Tier 2 capital is riskier and less reliable than Tier 1, as it's harder to liquidate and measure.  
    
*   Basel Accords set international standards for bank capital requirements to enhance financial stability.

## Exploring the Structure of Tier 2 Capital

Bank capital requirements were designated as part of the international [Basel Accords](https://www.investopedia.com/terms/b/basel_accord.asp). This set of recommendations was developed by the Basel Committee on Bank Supervision over a number of years dating back to the 1980s. According to the regulations, banks must maintain a certain amount of cash and/or other forms of [liquid assets](https://www.investopedia.com/terms/l/liquidasset.asp) on hand in order to meet their obligations. No more than 25% of a bank's capital requirements can be comprised of Tier 2 capital.

Bank capital is divided into two layers—Tier 1 or core capital and Tier 2 or supplementary capital. You calculate a bank's capital ratio by dividing its capital by its total risk-based [assets](https://www.investopedia.com/terms/a/asset.asp). The minimum capital ratio [reserve requirement](https://www.investopedia.com/terms/r/requiredreserves.asp) for a bank is set at 8%—6% of which must be provided by Tier 1 capital. The remaining must be Tier 2 capital. Along with Tier 1 capital, it provides a bank with a financial cushion in case it needs to liquidate its assets.

Tier 2 capital has four components:

*   **Revaluation reserves:** These are reserves created by the revaluation of an asset. A typical revaluation reserve is a building owned by a bank. Over time, the value of the [real estate](https://www.investopedia.com/mortgage/real-estate-investing-guide/) asset tends to increase and can thus be revalued.
*   **General provisions:** This category consists of losses that a bank may have of an as yet undetermined amount including from loans. The total general provision amount allowed is 1.25% of the bank's [risk-weighted assets](https://www.investopedia.com/terms/r/riskweightedassets.asp) (RWA).
*   **Hybrid capital instruments:** This type of capital is a mixture of both [debt](https://www.investopedia.com/terms/d/debt.asp) and [equity](https://www.investopedia.com/terms/e/equity.asp) instruments. [Preferred stock](https://www.investopedia.com/terms/p/preferredstock.asp) is an example of a hybrid instrument. A bank may include hybrid instruments in its Tier 2 capital as long as the assets are sufficiently similar to equity so losses can be taken on the face value of the instrument without triggering the [liquidation](https://www.investopedia.com/terms/l/liquidation.asp) of the bank.
*   **[Subordinated debt](https://www.investopedia.com/terms/s/subordinateddebt.asp):** Debt is subordinated in regard to ordinary bank depositors and other loans and securities that constitute higher-ranking [senior debt](https://www.investopedia.com/terms/s/seniordebt.asp). The minimum original term of this debt is over five years.

Tier 2 capital is split into upper and lower levels. Upper-level Tier 2 capital consists of securities that are perpetual—meaning they have no [maturity date](https://www.investopedia.com/terms/m/maturitydate.asp)—revaluation reserves, and fixed asset investments. Lower-level Tier 2 capital consists of subordinated debt and is generally inexpensive for a bank to issue.

## Nuances and Exceptions in Tier 2 Capital

[Undisclosed reserves](https://www.investopedia.com/terms/u/undisclosedreserves.asp) may be counted as part of a bank's Tier 2 capital in certain countries. These reserves are profits a bank earns that don't appear on publicly-available documents such as a bank's [balance sheet](https://www.investopedia.com/terms/b/balancesheet.asp). Even though they aren't disclosed, most banks still consider these reserves as real assets.

Regulatory authorities in some countries recognize their banks' undisclosed reserves as part of Tier 2 capital. Most countries, including the United States, do not allow this kind of capital to be used to legitimately meet reserve requirements.

> **Important**
>
> Most countries, including the United States, do not allow undisclosed reserves to be used to meet reserve requirements.﻿﻿

## Comparing Tier 2 and Tier 1 Capital: Key Differences

As mentioned above, a bank's capital reserves are divided into tiers. Unlike [Tier 2 capital, Tier 1 capital](https://www.investopedia.com/ask/answers/043015/what-difference-between-tier-1-capital-and-tier-2-capital.asp) is a bank's core capital or the primary source of funding for a bank. As such, it consists of almost all of an institution's funds including all of its disclosed reserves and any equity capital like [common stock](https://www.investopedia.com/terms/c/commonstock.asp). This capital helps a bank absorb any losses so it can continue its day-to-day operations. Because this level is composed of a bank's core capital, Tier 1 is a very good indicator of its financial health. This tier is considered more reliable than Tier 2 capital. That's because the capital is much easier to calculate accurately. The assets that fall into this category are also much easier to liquidate.

## What Is Tier 3 Capital?

[Tier 3 capital](https://www.investopedia.com/terms/t/tier3capital.asp) is tertiary capital banks use to support market risk in their trading activities. Tier 3 capital includes a greater variety of debt (short-term unsecured, subordinated debt) than tier 1 and tier 2 capital, but it's of lower quality. Tier 3 capital is being abolished under the Basel III accords.

## What Is Basel II?

[Basel II](https://www.investopedia.com/terms/b/baselii.asp) is the second of the three Basel Accords, aimed to create international standards for bank regulation and reduce risk in the banking system. It built upon Basel I, clarifying some of its rules and adding new ones. Basel II led to Basel III, which aims to address the inadequacies of the two earlier accords.

## What Is the Minimum Capital Adequacy Under Basel II?

Under Basell II, banks are required to maintain a capital reserve (Tier 1 + 2 + 3) equal to at least 8% of their risk-weighted assets.

## The Bottom Line

Banking regulations known as the Basel Accords require banks to hold different types of capital on hand and certain percentages of each. Having these types of liquid assets or cash balances out the risk-weighted assets that banks hold and increases the stability of the financial system.

Tier 2 capital is the extra reserve a bank holds. It is less reliable than tier 1 capital because it's composed of assets that are difficult to liquidate, and it's more difficult to measure accurately.

> **Article Sources**
>
> 1.  Federal Reserve. "[Regulatory Capital Rules: Regulatory Capital, Implementation of Tier 1/Tier 2 Framework](https://www.federalregister.gov/documents/2016/07/28/2016-12072/regulatory-capital-rules-regulatory-capital-implementation-of-tier-1tier-2-framework#sectno-reference-628.3%20)."
>     
> 2.  Federal Reserve. "[Federal Reserve Board Approves Final Rule to Help Ensure Banks Maintain Strong Capital Positions](https://www.federalreserve.gov/newsevents/pressreleases/bcreg20130702a.htm)."
>     
> 3.  Bank for International Settlements. "[International Convergence of Capital Measurement and Capital Standards](https://www.bis.org/publ/bcbs04.pdf)," Pages 4-5.
>     
> 4.  Bank for International Settlements. "[International Convergence of Capital Measurement and Capital Standards](https://www.bis.org/publ/bcbs04.pdf)," Page 19.
>     
> 5.  Bank for International Settlements. "[International Convergence of Capital Measurement and Capital Standards](https://www.bis.org/publ/bcbs04.pdf)," Pages 6-7.
>     
> 6.  Bank for International Settlements. "[International Convergence of Capital Measurement and Capital Standards](https://www.bis.org/publ/bcbs04.pdf)," Page 17.
>     
> 7.  Federal Reserve Bank of San Francisco. "[What Is Bank Capital and What Are the Levels or Tiers of Capital?](https://www.frbsf.org/education/publications/doctor-econ/2001/september/bank-capital/)"
>     
> 8.  Bank for International Settlements. "[Part 2: The First Pillar – Minimum Capital Requirements](https://www.bis.org/publ/bcbs128b.pdf)," Page 14.
>     
> 9.  Congressional Research Service. “[Bank Capital Requirements: A Primer and Policy Issues](https://crsreports.congress.gov/product/pdf/R/R47447).”
>     
> 10.  Bank for International Settlements. “[Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework](https://www.bis.org/publ/bcbs107.htm).”