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Basel Accord: Tier I & II Capital

Reading 17: Analysis of Financial Institutions

LOS C

1. Why was a Tier I and a Tier II Capital structure created?

2. Taking an intuitive approach, what criterion/criteria should an item on the balance sheet fulfill to be put into either Tier I or Tier II?

3. Based on the criterion/criteria, why have allowance for loan losses been included in Tier II Capital?

4. In what real-life contexts will this classification prove useful? What are the practical applications?

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Can any one help me out?

Hi, here is my point of view of your q’s:

1. The tier 1 and tier 2 was created by Basel Committee to regulate a minimum capital requirement for banks, cause banks are funded by third party funds (deposits), Basel require shareholders a minimum amount of funds given by them (so they also bear risk).

2. The Basel regulation explains what items can be classified as tier 1 and tier 2, basically:

tier 1 common capital (shareholders equity and retained earnings)

tier 1 capital (tier 1 common + preferred stock with no contractual cash flows or maturity)

tier 2 (proffered stock with maturity more than 5 years, “reserve for loan losses”, subordinated debt), basically is also called “supplementary capital”

3. Cause is view as supplementary capital from Basel Regulation and no core capital.

4. It is useful, since the Great Depression the Basel Committee has been improving regulations regarding capital of financial institutions and it’s primarily objective is to promote a healthier financial system and that will benefit shareholders but also all the people that save their money in that banks accounts 

Thanks Julio! That was insightful.

What is challenging to understand, however, is how the allowance for loan losses, being a contra-asset item on the balance sheet would be put into this tier-based classification that should normally involve only equity. What do you make of this?

@avmachado Interesting point.  I would have thought it would be more intuitive to have loss reserves reduce the denominator of the capital adequacy ratio (i.e., tier 1 + tier 2 capital / risk-weighted assets) rather than increase the numerator.