Basel Norms

For banks which are active globally, it is imperative to bolster their capital in accordance with the supervisory standards and guidelines formulated by the Basel Committee.

The committee which was constituted by Central Bank Governors of a Group of 10 countries in 1974 under the aegis of the Bank of International Settlements (BIS) has, over the years set out standards for capital measurement.

The BIS is regarded as the bank for central banks and is based in Basel in Switzerland.

Basel II norms require banks to set aside higher capital for more risky assets.

Tier 1 Capital
It is the core measure of a bank's financial strength from a regulator's point of view. It consists of the types of financial capital considered the most reliable and liquid, primarily Shareholders' equity. Examples of Tier 1 capital are common stock, preferred stock that is irredeemable and non-cumulative, and retained earnings.

Capital in this sense is related to, but different from, the accounting concept of shareholder's equity. Both tier 1 and tier 2 capital were first defined in the Basel I capital accord. The new, Basel II, accord has not changed the definitions in any substantial way.

Each country's banking regulator, however, has some discretion over how differing financial instruments may count in a capital calculation. This is appropriate, as the legal framework changes in different legal systems.

The theoretical reason for holding capital is that it should provide protection against unexpected losses. Note that this is not the same as expected losses - provisions, reserves and current year profits are for expected losses.

More specifically, Tier 1 Capital is a measure of capital adequacy of a bank, and is the ratio of a bank's core equity capital to its total risk-weighted assets. Risk weighted assets is the total of all assets held by the bank which are weighted for credit risk according to a formula determined by the Regulator (usually the country's Central Bank). Most Central Banks follow the BIS - Bank of International Settlements guidlelines in setting asset risk weights. Assets like cash and coins usually have zero risk weights, while unsecured loans might have a risk weight of 100%.
It is calculated as:-

Tier One Capital / Risk Weighted Assets

Tier 2 capital

It is a measure of a bank's financial strength with regard to the second most reliable form of financial capital, from a regulator's point of view. The forms of banking capital were largely standardised in the Basel I accord, issued by the Basel Committee on Banking Supervision and left untouched by the Basel II accord.

Tier 1 capital is considered the more reliable form of capital.

National regulators of most countries around the world have implemented these standards in local legislation. This includes the Board of Governors of the Federal Reserve System of the United States(FRB).

There are several classifications of tier two, capital. In the Basel I accord, these are categorised as undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt.

Undisclosed Reserves
Undisclosed reserves are not common, but are accepted by some regulators where a Bank has made a profit but this has not appeared in normal retained profits or in general reserves.

Revaluation Reserves
A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a Bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.

General Provisions
A general provision is created when a company is aware that a loss may have occurred but is not sure of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital.

Hybrid Instruments
Hybrids are instruments that have some characteristics of both debt and shareholders' equity. Provided these are close to equity in nature, in that they are able to take losses on the face value without triggering a liquidation of the Bank, they may be counted as capital.

Subordinated Term Debt
Subordinated term debt is debt that is not redeemable (it cannot be called upon to be repaid) for a set (usually long) term and ranks lower (it will only be paid out after) ordinary depositors of the bank.

A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings. Also known as "junior security" or "subordinated loan". In the case of default, creditors with subordinated debt wouldn't get paid out until after the senior debtholders were paid in full. Therefore, subordinated debt is more risky than unsubordinated debt.