Capital Tiers under Basel II

The constituents of capital under Basel II

Basel II provides for three tiers of capital.  Tier 1 is the purest and most reliable form of capital.  The agreement provides limits on how much Tier 2 or Tier 3 capital can be relied upon for capital adequacy, the idea being to make sure that there is always sufficient Tier 1 capital available.  Of course, Tier 1 capital needs no limits, the more the better.

The text below summarizes what is included in each of these tiers of capital, and also the limits laid down in respect of each.  This has been paraphrased from the Basel standard, and if you are interested in the actual text (straight from the horse’s mouth), look for paras 40(i) to 49(xviii) on pages 14-17; and Annex 1a on Pg 244 of the standard.  The Basel II document can be downloaded from the BIS’s website at http://www.bis.org/publ/bcbs128.pdf

The three tiers of capital:

Tier 1 capital – also called ‘core capital’ or ‘basic equity’
Tier 1 capital includes:

• Equity capital
• Disclosed reserves

The above two are generally known numbers that can be seen in the published accounts.  Tier 2 capital cannot exceed Tier 1 capital, which means that effectively at least 50% of a bank’s capital base should consist of Tier 1 capital.
Tier 1 capital is the most stable and reliable source of funding for a bank’s operations.

Tier 2 capital – also called ‘supplementary capital’
Tier 2 capital includes:

1. Undisclosed reserves: These are ‘hidden’ reserves a bank may have created.  These reserves generally get created when a bank charges an expense to the P&L which is not going to materialize.  The liability in respect of such a expense therefore does not represent a true liability owed to outsiders, but is really shareholders’ money, and is therefore economically not different from disclosed reserves except that it is not visible as such in the published accounts.
2. Revaluation reserves: These are reserves created through an upward valuation of assets which are otherwise supposed to be carried in the books at historical cost.  For example, a bank may own land or buildings carried at the cost at which they were acquired many years ago, but have appreciated in value.  Generally, accounting standards do not permit recognizing such gain unless these assets are held as stock-in-trade.  Yet, the bank can count upon such higher asset values as gains that can be claimed by shareholders, and are a part of the shareholders’ equity.  Revaluation gains can be included for capital calculations only if approved by the regulatory authorities.
3. General provisions or general loan-loss reserves:  To the extent these reserves are over and above the amount truly needed to take care of losses in respect of the assets against which they exist, these reserves are of the same type as disclosed reserves.  There are limits to the extent to which these can be included in capital.
4. Hybrid debt capital instruments: These are quasi-equity instruments, such as perpetual preference shares, long term preferred shares, perpetual debt instruments that cannot be called, and mandatory convertible debt.
5. Subordinated term debt: This is generally a liability, but if subordinated term debt was issued with an original term to maturity of over five years, then it may be included as Tier 2 capital to a maximum of 50% of Tier 1 capital.  Note that it is the original term to maturity that is relevant here.  Also, during the last 5 years of maturity, a discount or amortization factor of 20% per year will be applied to the amount of subordinated term debt to reflect the reduction in value of this source of capital available to support the bank’s funding needs.

Tier 3 capital
Tier 3 capital to cover market risks may be used only at the discretion of the national authorities, and includes only short term subordinated debt that satisfies the following conditions: 

• Unsecured, subordinated and fully paid up,
• Have an original maturity of at least 2 years,
• Be subject to a lock-in clause that stipulates that neither interest nor principal may be paid (even when due at maturity) if the bank is below its minimum capital requirement or if such payment makes the bank go below the minimum capital requirement.

Note that Tier 3 capital can only be used in respect of market risk.  Tier 3 capital is limited to 250% of a bank’s Tier 1 capital that is required to support market risks.

Limits

• Tier 2 is limited to 100% of Tier 1, in other words Tier 2 capital cannot exceed Tier 1 capital
• Tier 3 capital can only be used to support market risk capital requirements, and is limited to 250% of Tier 1 capital being applied to market risk exposures.  If Tier 3 capital is used for capital adequacy, then any Tier 2 capital also used for the same counts towards this 250% limit.  To illustrate numerically, if $100 is the Tier 1 capital available for market risk, then the maximum Tier 3 capital (including any Tier 2 elements substituted for Tier 3) can be 250% x $100 = $250.  The total capital available then is $350, of which $100 is Tier 1.  Thus the minimum Tier 1 capital needed for market risk ends up being about 28.5% ($100/$350).

 An interesting thing to note is the difference between ‘subordinated term debt’ under Tier 2 and the ‘short term subordinated debt’ under Tier 3.  The distinction is based upon the years to maturity at the time the debt was issued.  The remaining time to maturity is not relevant.  For the subordinated term debt included under Tier 2, the amount that can be counted towards capital is reduced by 20% for every year when the debt is due within 5 years.  This takes care of the time to maturity problem for Tier 2 subordinated debt.  For Tier 3 short term subordinated debt, this is not an issue because debt will only qualify for Tier 3 if it has a lock-in clause stipulating that the debt is not required to be repaid if the effect of such repayment is to take the bank below minimum capital requirements.