Tier 2 Capital: Definition, Ratio & Calculation

Instructor: Michelle Reichartz

Michelle has lead multiple training initiatives and has a master's degree in Business Administration.

In this lesson, you will learn about Tier 2 Capital, how it differs from the assets known as Tier 1 Capital, and the calculations required for the Tier 2 Capital ratio formula.

Knowing Your Risky Assets

It's important to ensure that you always have enough capital to pay your bills and continue to live at the standard your family is used to. Capital such as cash and stocks are known to be fairly secure since there is very little risk associated with holding them. Cash is cash, right? And, stocks can be sold for cash - making them a somewhat solid form of capital.

However, what about those more risky forms of capital? These are the ones that come with strings attached and no guarantee of return. The most common form of this used by typical families are loans. You're given capital in exchange for specific rules and promises to follow payback schedules.

It is this same premise that banks use to define Tier 2 Capital.

Tier 2 Capital Defined

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.

The capital that falls within the definition of Tier 2 is revaluation reserve, undisclosed reserves, hybrid security, and subordinate debt.

Revaluation reserve is capital earned when the revaluation of an asset leads to it gaining value compared to its previously determined value.

Undisclosed reserves are the reserves a company is holding that are not being disclosed on their financial statements.

Hybrid security is a financial security that includes the features of two or more different security interests. For example, the most common type of hybrid security is convertible bonds with the features of an ordinary bond.

Subordinate debt is any type of security interest (such as bonds or stock) that hold a lower priority interest than another security. For example, if the issuing firm for a certain set of bonds were liquidated, the secured bonds would be paid before the unsecured bonds. In this case, the unsecured bonds would be considered the subordinate debt.

In each case, the capital under the Tier 2 Capital definition holds some type of risk. Either there is a risk that the capital could not be paid out or it is being hidden from view. The capital held here can also be difficult to calculate. This is what places it in the lower tier.

Tier 2 Capital Ratio

Just like the Tier 1 capital, Tier 2 capital also has a ratio. This is the formula utilized to describe the capital being held versus what's known as total risk-weighted assets (RWAs). Risk-weighted assets are the assets held by the bank that are weighted by its credit risk.

The result of the formula is a percentage. The acceptable amount of Tier 2 capital held by a bank is at least 2%, where the required percentage for Tier 1 capital is 6%.

The formula is Tier 2 capital divided by risk-weighted assets multiplied by 100 to get the final percentage.

Let's look at an example. Bank ABC has $80 in Tier 2 capital. They've lent a total of $5,000 with a risk weight at 75%.

The calculation for their Tier 2 Capital Ratio would be as follows:

Tier 2 Capital: $80

divided by

Risk-Weighted Capital: $5,000 multiplied by 75% = $3,750

multiplied by 100

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