Tier I and Tier II Capital

In the realm of banking and financial regulation, Tier I and Tier II Capital represent the two main components of a bank’s regulatory capital, as defined under the Basel Accords (Basel I, II, and III) formulated by the Bank for International Settlements (BIS).
These capital classifications are fundamental to the Capital Adequacy Framework, which ensures that banks maintain sufficient capital buffers to absorb losses, safeguard depositors, and maintain stability in the financial system.

Background: Capital Adequacy Framework

Banks are required by regulators (such as the Reserve Bank of India (RBI) or Federal Reserve) to maintain a minimum Capital to Risk-weighted Assets Ratio (CRAR), also called the Capital Adequacy Ratio (CAR).
This ratio measures a bank’s capital relative to its risk-weighted assets (RWA) — that is, loans and other exposures adjusted for credit, market, and operational risks.
Capital Adequacy Ratio (CAR)=Tier I Capital + Tier II CapitalRisk-Weighted Assets×100\text{Capital Adequacy Ratio (CAR)} = \frac{\text{Tier I Capital + Tier II Capital}}{\text{Risk-Weighted Assets}} \times 100Capital Adequacy Ratio (CAR)=Risk-Weighted AssetsTier I Capital + Tier II Capital​×100
The Basel III Norms (implemented globally after the 2008 financial crisis) prescribe that banks must maintain:

• Minimum CAR: 8% (Basel standard); 9% for Indian banks as per RBI norms.
• Tier I Capital: At least 6% of RWA.
• Common Equity Tier I (CET I): At least 4.5% of RWA.

I. Tier I Capital (Core Capital)

Tier I Capital, also known as Core Capital, is the most reliable and permanent source of financial strength for a bank. It primarily consists of capital that is readily available to absorb losses while the bank remains operational.

Components of Tier I Capital

1. Common Equity Tier I (CET I):
   • Ordinary (Common) Shares issued by the bank.
   • Share Premium (Paid-up Capital Surplus).
   • Statutory Reserves and Retained Earnings (undistributed profits).
   • Other Comprehensive Income (OCI).
   • Less: Deductions such as deferred tax assets, goodwill, and intangible assets.

   CET I is considered the highest quality capital since it is fully loss-absorbing on a going-concern basis.

2. Additional Tier I (AT I) Capital:
   • Perpetual Non-Cumulative Preference Shares (PNCPS).
   • Perpetual Debt Instruments (PDIs) that have no maturity date and can absorb losses.
   • Instruments must have no fixed maturity and may be written down or converted to equity in case of financial stress.

Key Characteristics of Tier I Capital

• Permanently available to cover losses.
• Freely available to meet the bank’s obligations.
• Does not have a fixed repayment or maturity obligation.
• Absorbs losses without the bank being required to cease operations.

Importance of Tier I Capital

Tier I capital represents the core financial strength of a bank and serves as a safety cushion against unexpected losses. It provides confidence to depositors and regulators about the bank’s solvency.

II. Tier II Capital (Supplementary Capital)

Tier II Capital, also known as Supplementary Capital, includes instruments that are less permanent in nature compared to Tier I. These funds can absorb losses only in the event of a bank’s liquidation or closure (i.e., they are gone-concern capital).

Components of Tier II Capital

1. Subordinated Debt:
   • Long-term debt instruments that rank below deposits and other liabilities in case of liquidation.
   • Must have a minimum maturity of 5 years.
2. Hybrid Capital Instruments:
   • Instruments with characteristics of both debt and equity.
3. General Provisions and Loan-Loss Reserves:
   • Reserves created for potential but unspecified loan losses.
   • Can be counted up to a prescribed limit (usually 1.25% of risk-weighted assets).
4. Revaluation Reserves:
   • Created due to the revaluation of assets (e.g., property or investments).
   • Included at a discounted rate (typically 45%) to account for potential volatility.
5. Undisclosed Reserves:
   • Profits retained but not disclosed in published financial statements (rarely used under modern accounting standards).

Key Characteristics of Tier II Capital

• Less permanent than Tier I.
• Available to absorb losses only when the bank is winding up.
• Includes instruments with fixed maturity and subordination clauses.
• Carries higher risk due to repayment obligations.

III. Differences between Tier I and Tier II Capital

IV. Capital Adequacy under Basel III

The Basel III framework (adopted after the 2008 financial crisis) strengthened capital requirements to make the global banking system more resilient.
Under Basel III norms, the following capital structure is prescribed:

Thus, total regulatory capital (including buffers) typically exceeds 10.5% of risk-weighted assets under Basel III standards.

V. Importance of Capital Structure in Banking

1. Financial Stability: Adequate capital ensures resilience against losses and prevents bank failures.
2. Depositor Confidence: High Tier I capital instils trust in the bank’s solvency.
3. Regulatory Compliance: Meeting Basel III norms avoids penalties and restrictions.
4. Economic Growth: Well-capitalised banks can lend more, supporting investment and growth.
5. Crisis Prevention: Strong capital buffers mitigate the risk of systemic crises, as witnessed during the 2008 global financial meltdown.

VI. Example: RBI Norms for Indian Banks

The Reserve Bank of India (RBI) has implemented Basel III capital standards with some national adjustments:

• Minimum Total Capital Ratio: 9% of RWA.
• Minimum Tier I Capital: 7% (including Capital Conservation Buffer).
• Common Equity Tier I (CET I): 5.5% (minimum).
• Leverage Ratio: 4.5% for domestic banks.

These norms ensure that Indian banks remain adequately capitalised and capable of absorbing shocks.