Understanding corporate finance: regulatory capital: tiers of capital
‘Tiers’ of capital
Tier 1 capital
Tier 1 capital is the highest form of capital of the bank and is regarded by the Financial Services Authority (FSA) as broadly equivalent to equity. This means it must be capable of absorbing losses so that the bank or building society can continue trading even if it makes losses up to the value of that capital. The majority of this capital is made up of:
- fully paid-up ordinary shares;
- perpetual non-cumulative preference shares;
- retained earnings (profits taken to reserves after payment of dividends and tax);
- in the case of a building society, permanent interest bearing shares (PIBS) (CFM14140).
The capital must be permanent which means it is undated. The capital must be fully paid so that the bank has the funds. There are further requirements designed to ensure that the holder of the instrument can’t take priority over the depositors of the bank. For example, dividends must be discretionary so that they cannot be paid in the absence of distributable profits.
GENPRU2.2.29 (see CFM14050) provides that at least 50% of tier 1 capital must be accounted for as core tier one capital. This is defined as an item of capital stated in stage A of the capital resources tables in Annexes 2 & 3 in GENPRU 2 to be core tier 1 capital - fully paid-up ordinary shares and retained earnings (profits taken to reserves after payment of dividends and tax.
Certain types of Tier 1 capital are termed ‘innovative Tier 1 capital’ (CFM14130).
Tier 2 capital
Tier 2 capital is debt that is subordinated to the majority of other calls on the bank. It is divided into Upper Tier 2 and Lower Tier 2. Upper Tier 2 debt is undated. It must be of a type unlikely to threaten the solvency of the bank.
Lower Tier 2 capital is dated normally with a maturity date of more than 5 years, and cannot exceed 50% of Tier 1.
Tier 2 capital as a whole cannot exceed Tier 1 capital.
Tier 3 capital
This is the capital that supports trading book activity or foreign currency risk. Broadly it is short-term subordinated debt with a minimum maturity of 2 years. To date, most UK banks do not have Tier 3 capital.