Background
Tier 2 Capital forms a part of the regulatory capital framework designed to ensure banks have enough reserve to absorb a certain amount of loss before becoming insolvent. It acts as a financial shock absorber, supplementing Tier 1 Capital, which is composed of core equity and disclosed reserves.
Historical Context
The concept of splitting bank capital into Tier 1 and Tier 2 categories was formalized by the Basel Accords (Basel I in 1988, Basel II in 2004, and Basel III in 2010), international banking regulations set by the Basel Committee on Banking Supervision (BCBS). These accords aimed to strengthen the regulation, supervision, and risk management within the banking sector.
Definitions and Concepts
Tier 2 Capital refers to a bank’s supplementary capital and is seen as less secure than Tier 1 Capital. It includes items such as:
- Subordinated term debt,
- Hybrid capital instruments,
- Revaluation reserves,
- General loan-loss reserves,
Tier 2 Capital is considered less stable in absorbing losses than Tier 1 Capital, as it is not fully available to cover losses unless the bank is winding up.
Major Analytical Frameworks
Classical Economics
- little relevance; primarily focused on market equilibria without emphasizing banking structure.
Neoclassical Economics
- minimal engagement with concepts of regulatory capital.
Keynesian Economics
- recognizes the importance of stable banking systems but doesn’t heavily focus on capital tier structuring.
Marxian Economics
- critiques on capital dominance could extend to discussing the hierarchical nature of capital structures in banking.
Institutional Economics
- investigates the role of regulations and institutions (such as Basel Accords) in stabilizing economic practices, relevant to the discussion on Tier 2 Capital.
Behavioral Economics
- might approach how these capital structures influence the behavior of banks and investors but does not directly interact with the concept.
Post-Keynesian Economics
- emphasizes the importance of safe and regulated banking practices, arguing the necessity of robust capital regulations.
Austrian Economics
- might argue against stringent capital regulations, advocating for minimal interference in banking practices by regulatory bodies.
Development Economics
- highlights the importance of strong banking systems for economic development, where Tier 2 Capital could play a supporting role.
Monetarism
- emphasizes the stability provided by adequate banking regulations, aligning closely with the need for structured capital frameworks.
Comparative Analysis
Comparing the significance and stability of Tier 1 versus Tier 2 Capital is crucial:
- Enhanced stability with Tier 1 tends to ensure enhanced solvent status for banks due to its higher liquidity and permanent nature.
- Tier 2 capital, while less durable, provides additional buffer, absorbing larger losses akin to a secondary defensive layer.
Case Studies
Analyzing banking regulations and capital structure during financial crises, such as the 2008 Global Financial Crisis, helps underscore the significance:
- Citibank and many other institutions depended heavily on Tier 2 capital buffers.
- The necessity for enhanced Tier 1 capital under Basel III subsequent to observed limitations of covering large-scale losses with Tier 2 alone.
Suggested Books for Further Studies
- “Banking Regulation: Its Purposes, Implementation, and Effects” by Kenneth Spong
- “The Economics of Banking” by Kent Matthews and John Thompson
- “Rethinking the Economics of Banking” by Acharya Moritz
Related Terms with Definitions
Capital Adequacy Ratio (CAR): A measure of a bank’s capital, ensuring it has enough on hand to absorb potential losses. It is calculated using both Tier 1 and Tier 2 capital.
Basel III: A global regulatory framework on bank capital adequacy, stress testing, and market liquidity risk designed to strengthen regulation, supervision, and risk management within the banking sector.
Subordinated Debt: A form of debt which ranks below other forms of debt and other claims in terms of claims on assets or earnings.
