A bank’s capital is made up of share capital, reserves and a series of dated and hybrid capital instruments, which are divided, based on their charatceristics, into categories referred to as Lower Tier 2, Upper Tier 2 and Tier 1. Capital in the form of debt instruments is always sub-ordinated because senior debt does not count as bank capital. This debt has to comply with regulatory guidelines concerning its characteristics in order to count as capital. In setting these guidelines bank regulators are primarily concerned with the protection of depositors such that bank capital can be regarded as a safety net that absorbs a certain level of unexpected losses without the interests of depositors being affected.

Tier 1

Tier 1 is a bank’s core capital. The main components of Tier 1 are ordinary shareholders equity; retained earnings; perpetual (undated) non-cumulative preferred stock (Tier 1 Preferred); reserves created by appropriations of retained earnings, share premiums and other surpluses; and minority interests. The equity and reserves element of Tier 1 is often referred to as ‘Core Tier 1’. The Tier 1 Preferred elements are often known as ‘hybrid instruments’ because they have a mix of both debt and equity features.

The main characteristics of Tier 1 instruments are:

  • there should be no contractual obligation to pay dividends or interest to Tier 1 holders with the deferral of a coupon usually being at the option of the issuer
  • deferred coupons or dividends are non-cumulative
  • Tier 1 should be able to absorb losses before, or instead of, general creditors
  • Tier 1 preferred must be perpetual but the FSA allows a limited step-up associated with a call after the tenth anniversary of the issue

Upper Tier 2

The main components of Upper Tier 2 are perpetual deferrable sub-ordinated debt (including debt convertible into equity); revaluation reserves from fixed assets and fixed asset investments; and general provisions.

The main characteristics of Upper Tier 2 debt are:

  • perpetual, senior to Tier 1 preferred and equity
  • coupons are deferrable and cumulative
  • interest and principal can be written down

Lower Tier 2

Lower Tier 2 capital is relatively standard in form and cheap for banks to issue. The Basel Accord states that only 25% of a bank’s total capital can be lower Tier 2.

Basel 3

Basel 3 will take effect from 1 January 2013 and will apply stricter definitions to the various forms of bank capital. In particular it seems that virtually all existing Tier 1 securities and preference shares will not count as Tier 1 under Basel 3. For those who like the detail below is a list of the 14 criteria laid down for inclusion in Additional Tier 1 Capital Under Basel 3:

  1. Issued and paid-in.
  2. Subordinated to depositors, general creditors and subordinated debt of the bank.
  3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors.
  4. Is perpetual with no maturity date and no step-ups or other incentives to redeem.
  5. May be callable at the initiative of the issuer only after a minimum of five years providing:
    a. To exercise a call option a bank must receive prior supervisory approval; and
    b. A bank must not do anything which creates an expectation that the call will be exercised; and
    c. Banks must not exercise a call unless:
    i. They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank; or
    ii. The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.

  6. Any repayment of principal (eg through repurchase or redemption) must be with prior supervisory approval and banks should not assume or create market expectations that supervisory approval will be given.
  7. Dividend/coupon discretion:
    1. the bank must have full discretion at all times to cancel distributions/payments
    2. cancellation of discretionary payments must not be an event of default
    3. banks must have full access to cancelled payments to meet obligations as they fall due
    4. cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders.
  8. Dividends/coupons must be paid out of distributable items.
  9. instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organisation’s credit standing.
  10. The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law.
  11. Instruments classified as liabilities for accounting purposes must have principal loss absorption through either (i) conversion to common shares at an objective pre-specified trigger point or (ii) a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point. The write-down will have the following effects:
    1. Reduce the claim of the instrument in liquidation;
    2. Reduce the amount re-paid when a call is exercised;
    3. and Partially or fully reduce coupon/dividend payments on the instrument.
  12. Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument.
  13. The instrument cannot have any features that hinder recapitalisation, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame.
  14. If the instrument is not issued out of an operating entity or the holding company in the consolidated group (eg a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Additional Tier 1 capital.