Tier 2 Capital

Tier 2 Capital is the supplementary capital of a bank that provides additional loss absorption capacity after Tier 1 Capital is exhausted. It is less permanent and less loss-absorbing than Tier 1, and its inclusion in total capital is subject to limits set by regulators.

What Is Tier 2 Capital?

Tier 2 Capital consists of:
– **Subordinated debt**: long-term bonds that are junior to depositor claims and senior to equity; typically with a minimum maturity of 5 years
– **Revaluation reserves**: unrealised gains on assets (e.g., appreciation in value of fixed assets held)
– **General provisions**: provisions held against unidentified potential future losses
– **Hybrid capital instruments**: bonds that have some characteristics of both debt and equity

Under Basel III, Tier 2 Capital can be at most 100% of Tier 1 Capital (so total capital = maximum 2x Tier 1).

Tier 2 vs Tier 1 Capital

| Feature | Tier 1 | Tier 2 |
|———|——–|——–|
| Permanence | Permanent | Has maturity dates |
| Loss absorption | Goes concern basis | Gone concern basis |
| Seniority in liquidation | Junior (last to be paid) | Senior to equity but junior to depositors |
| RBI minimum | 6% of RWA | Supplementary |

Tier 2 is “gone concern” capital: it absorbs losses primarily in liquidation (when the bank is being wound up), not while the bank is still operating.

Subordinated Debt Bonds in India

Banks issue subordinated bonds (long-term infrastructure bonds or Tier 2 bonds) to count toward Tier 2 Capital. These carry higher interest rates than senior bonds because they are junior in the payment hierarchy.

Practical Example

A bank has:
– Tier 1 Capital: Rs 2,000 crore
– Subordinated bonds: Rs 1,000 crore
– Revaluation reserves (eligible portion): Rs 200 crore
– Total Tier 2 Capital: Rs 1,200 crore

Under Basel III, Tier 2 is limited to Rs 2,000 crore (equal to Tier 1). The full Rs 1,200 crore is eligible. Total capital = Rs 3,200 crore.

Key Takeaways

– Tier 2 Capital supplements Tier 1; consists of subordinated debt, revaluation reserves, and general provisions
– Less permanent and less loss-absorbing than Tier 1; classified as gone-concern capital
– Capped at 100% of Tier 1 Capital for inclusion in total capital calculation
– Subordinated bonds issued by banks to raise Tier 2 Capital carry higher yields but lower seniority than deposits
– Investors in bank subordinated bonds must understand they are at risk before depositors in a liquidation