Tier 2 Capital

Tier 2 capital refers to any capital that is subordinate to tier 1 capital. Tier 1 capital consists of common equity shares and preferred stock that are not subordinate to any other security. Tier 2 capital includes various instruments, such as subordinated debt, convertible debt, and hybrid securities.

Characteristics of Tier 2 Capital:

• Subordinated to Tier 1 Capital: Tier 2 capital is subordinate to tier 1 capital in the capital hierarchy. It is not used to meet the firm’s required minimum capital ratio, but is used to supplement tier 1 capital in times of need.
• Lower Priority: Holders of tier 2 capital have a lower priority in the event of bankruptcy than holders of tier 1 capital. They are only entitled to receive payments if there are any funds remaining after satisfying the claims of tier 1 creditors.
• Typically Lower Returns: Tier 2 capital typically offers lower returns than tier 1 capital. This is because investors know that they are at a higher risk of losing their investment in the event of bankruptcy.
• High Liquidity: Tier 2 capital can be more liquid than other types of subordinated debt, such as mezzanine debt. This is because there is a greater market for tier 2 capital than for other subordinated debt.
• Collateralized or Uncollateralized: Some tier 2 capital instruments, such as subordinated debt, are collateralized by specific assets, while others are not. Uncollateralized tier 2 capital is known as high-yield debt.

Examples of Tier 2 Capital Instruments:

• Subordinated debt
• Convertible debt
• Hybrid securities
• Asset-backed securities
• Emerging markets debt

Uses of Tier 2 Capital:

• To supplement tier 1 capital in times of need
• To meet regulatory requirements for minimum capital ratios
• To provide additional liquidity to the firm
• To generate additional returns for investors

Note: The specific definition and composition of tier 2 capital may vary depending on the industry and jurisdiction.