Introduction to the Concept of Tier Capital

Under the provisions of Basel Banking Reforms, banks are required to maintain different types of tier capital with purpose of making banks more reliable and stable and lower the risks relating to various areas. The tier capital is categorized and explained as below

Tier 1 capital

Tier 1 capital is the core measure of a bank’s financial strength from a regulator’s point of view. It consists of the types of financial capital considered the most reliable and liquid, primarily equity. Examples of Tier 1 capital are common stock, preferred stock that is irredeemable and non-cumulative, and retained earnings. The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses — provisions and reserves are for expected losses.

Tier 2 capital

Tier 2 capital is a measure of a bank’s financial strength with regard to the second most reliable forms of financial capital, from a regulator’s point of view. It consists of accumulated after-tax surplus of retained earnings, revaluation reserves of fixed assets and long-term holdings of equity securities, general loan-loss reserves, hybrid (debt/equity) capital instruments, and subordinated debt.

Tier 1 capital is the most reliable form of capital.

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