Tier 1 Capital vs Tier 2 Capital: What’s the Difference?

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You’re given capital in exchange for specific rules and promises to follow payback schedules. BCBS published Basel III in 2009, following the 2008 financial crisis. Basel III seeks to improve the banking sector’s ability to deal with financial stress, improve risk management, and strengthen a bank’s transparency. (viii) The Enterprise, or an entity that the Enterprise controls, has not purchased and has not directly or indirectly funded the purchase of the instrument.

What Does a High Tier 1 Capital Ratio Mean?

After each successful Reg A offering, the issuer must submit for a new SEC qualification. Tier 3 capital is limited to 250% of a bank’s Tier 1 capital that is required to support market risks. Whereas Tier 1 Capital is commonly known as a bank’s core capital, Tier 2 Capital is known a bank’s supplementary capital. As the name insinuates, the capital that falls within this bucket is secondary to Tier 1 and is seen as being of a higher risk than its core capital partners. Tier 3 capital debt may include a greater number of subordinated issues when compared with tier 2 capital. Defined by the Basel II Accords, to qualify as tier 3 capital, assets must be limited to no more than 2.5x a bank’s tier 1 capital, be unsecured, subordinated, and whose original maturity is no less than two years.

On the other hand, Tier 2 capital includes revalued reserves, undisclosed reserves, and hybrid securities. Since this type of capital has lower quality, is less liquid, and is more difficult to measure, it is known as supplementary capital. If you decide to offer your securities under Tier 2, you are required to provide continual reports and audited financial statements to the SEC on a semi-annual basis. You are also required to issue a report on the final status of your offering. Keep in mind that Tier 2 offerings might have some additional requirements or limitations on the amount of money a non-accredited investor can invest. You need to keep an eye on these requirements to ensure you do not violate any rules.

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Under the Basel Accord, a bank has to maintain a certain level of cash or liquid assets as a ratio of its risk-weighted assets. The Basel Accords are a series of three sets of banking regulations that help to ensure financial institutions have enough capital on hand to handle obligations. First, if you are issuing difference between tier 1 and tier 2 capital securities under Tier 1, your company is allowed to offer a maximum of $20 million dollars over a 12-month period. In addition, you are required to file offering statements with the SEC, and they need to be qualified by state regulators and all of the states in which you plan to sell your securities.

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In addition, an instrument issued by an Enterprise to its employee stock ownership plan does not violate the criterion in paragraph (b)(1)(x) of this section. Capital in this sense is related to, but different from, the accounting concept of shareholders’ equity. Both Tier 1 and Tier 2 capital were first defined in the Basel I capital accord and remained substantially the same in the replacement Basel II accord. Tier 2 capital represents “supplementary capital” such as undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt.

Tier 2 capital is supplementary capital because it is less reliable than tier 1 capital. It is more difficult to accurately measure due because it is composed of assets that are difficult to liquidate. Often banks will split these funds into upper- and lower-level pools depending on the characteristics of the individual asset.

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After the financial crisis in 2008, the Bank of International Settlements (BIS) began setting stricter CAR requirements to protect depositors. While Tier 2 requires ongoing financial reporting to the SEC, it enjoys Blue Sky Exemptions. That means Tier 2 offerings can raise money in all states without registering in each of them. A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example is the situation where a bank owns the land and building of its head-offices and bought the properties for $100 a century ago.

In addition, tier 2 capital incorporates general loan-loss reserves and undisclosed reserves. 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. 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.