What it means
Regulatory capital is the money a bank must hold to absorb losses, and it is divided into tiers according to quality. Tier 1 is the strongest and includes common equity, Tier 2 is weaker and includes some subordinated debt, and Tier 3 was weaker still.
The tiers allow supervisors to see how much of a bank's cushion is truly loss absorbing. Tier 3 was introduced in the 1990s, when international rules were extended to cover market risk, which is the risk of losses from changes in the prices of securities, currencies and commodities.
It allowed banks to use short-term subordinated debt, with a minimum original maturity of two years, to support those risks. A lock-in clause stopped the bank from repaying it if doing so would leave it short of capital.
The reason for the tier was practical. Banks argued that trading positions change quickly and can be backed by shorter-term funding, so they should not have to meet all of their market risk requirement with permanent capital.
Regulators accepted this, with limits on how much Tier 3 could be used. Experience in the financial crisis showed that short-term and low-quality capital did not absorb losses well when markets were under stress.
The Basel III reforms therefore concentrated on common equity and abolished Tier 3 capital. Banks now meet their requirements with Tier 1 and Tier 2 capital only.
For a manager, the story is a useful lesson about why capital quality matters as much as quantity. Older textbooks and accounts may still mention Tier 3, so it helps to know what it meant.
Any current analysis of bank strength should focus on the common equity ratios.
In practice
Real-world examples.
Example
A historical case study in a banking course describes a bank in the late 1990s that issued short-term subordinated notes to raise Tier 3 capital. The notes supported its trading book without requiring new shares. Students compare this with today's focus on common equity.
Example
An analyst reviewing a bank's old annual report finds a line labelled Tier 3 capital. She checks the notes to confirm it was subordinated debt with a lock-in clause. She adjusts the figures when comparing the bank with its modern peers.
Example
A regulator drafting a speech on lessons from the crisis cites the removal of Tier 3 as an example of raising capital quality. She explains that capital which cannot absorb losses in stress does not serve its purpose. The speech uses it to illustrate the aims of the new rules.
Formula
Calculation
Maximum Tier 3 capital under the old rules = 250% x Tier 1 capital allocated to support market risk
Suppose a bank's market risk capital requirement under an earlier regime was $200,000,000. It held Tier 1 capital of $80,000,000 allocated to market risk and the old rules allowed Tier 3 up to 250% of that amount, meaning 2.5 x 80,000,000 = $200,000,000 as a cap. To meet the requirement, the bank needed 200,000,000 - 80,000,000 = $120,000,000 from other sources, and it could issue $120,000,000 of Tier 3 debt, which was within the cap. Under today's rules, the full $200,000,000 would have to come from Tier 1 and Tier 2 capital.Case study
Seen in the real world.
Harbourview Bank is an illustrative, fictional institution that, under older rules, relied heavily on Tier 3 capital to support a large trading business. In a calm year, it issued $150,000,000 of short-term subordinated notes and counted them towards its market risk requirement.
When markets became turbulent, the bank suffered trading losses, and the lock-in clause prevented it from repaying the notes as they fell due. Investors who had expected repayment complained, and the bank's funding costs rose sharply.
In this illustrative scenario, the supervisor required the bank to replace the notes with common equity. The episode made the board realise that cheaper short-term capital was least available when it was most needed, and it shifted the bank's capital plan towards retained profits.
Watch out
Common mistakes.
- Assuming Tier 3 capital still counts under current international rules, when Basel III removed it.
- Treating all capital as equal, when the quality of loss absorption differs sharply between tiers.
- Confusing Tier 3 with Tier 2, which is a longer-term and still recognised category of supplementary capital.
Questions
People also ask.
What was Tier 3 made of?
Mainly short-term subordinated debt, with a lock-in feature so that it could not be repaid if the bank would then fall below its requirement.
Why was it removed?
Because it was not reliable at absorbing losses in stress, and regulators wanted capital rules to rely on higher-quality capital.
Does it still matter?
Mostly for understanding historical accounts and the evolution of banking regulation.
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