What is meant by Tier-I and Tier-II capital?

The two tiers of capital was defined under the Basel-I or Basel capital accord which is the capital measurement system for banks. The system with prime focus on credit risk determined capital as well as structure of risk weights for banking entities.

From the point of view of the regulator, tier-I capital is the primary measure which reflects the financial strength of the banking entity. Hence, tier-I capital is the core capital whereas tier-II capital is the secondary or subordinate capital.

Tier-I capital: Tier-I capital comprises forms of financial capital that is highly liquid as well as reliable. Examples of tier-I capital include common stock; preferred stock; paid up capital; statutory reserves; other disclosed free reserves; capital reserves representing surplus from the sale proceeds of the assets; Perpetual Non-Cumulative Preference Shares; Investment Fluctuation Reserves; and Innovative Perpetual Debt Instruments (IPDI).

This form of capital however does not includes intangible assets, equity investment in subsidiaries and losses (current as well as carried forward losses of the past).

The rationale for maintaining capital is to offer protection against any unexpected losses. For expected or anticipated losses, reserves and provisions are made.

Tier-II capital: Tier-II capital also reflecting financial strength of the banking entity is the supplementary capital and comprises cumulative perpetual preference shares and undisclosed reserves; debt capital instruments; revaluation reserves; loss reserves and general provisions; hydrid debt capital financial instruments including bonds; long-term unsecured loans; redeemable cumulative preference shares and perpetual cumulative preference shares.

With the implementation of Basel III norms in a phased manner from April 1, 2013, the Reserve Bank of India has directed banks in India to maintain a minimum of 7% of their risk-weighted assets (RWA) as Tier-I capital on a continuous basis. Risk-weighted assets refer to assets with different risk profiles, for instance loans backed by a collateral will be less risky in comparison to personal loans that are unsecured in nature.

Further, as per its final guidelines concerning Basel III capital requirement, the RBI stipulated total capital ratio that includes both tier-I and tier-II capital to be at least 9%.

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