Definition:

Tier 2 Capital, also known as supplementary capital, includes a bank's undisclosed reserves, revaluation reserves, general loan-loss reserves, hybrid instruments, and subordinated term debt. It is used to absorb losses in the event of a bank winding-up and provides a secondary layer of financial security.

Formula:

Tier 2 Capital = Undisclosed Reserves + Revaluation Reserves + General Loan-Loss Reserves + Hybrid Instruments + Subordinated Term Debt

How to use the metric:

Tier 2 Capital is used by regulators to assess a bank's financial strength and its ability to withstand financial stress. It is part of the calculation of the bank's total capital ratio, which is used to ensure that banks have enough capital to cover their risk-weighted assets.

Limitations:

Tier 2 Capital is less reliable than Tier 1 Capital because it is more difficult to liquidate and may not be available in times of financial distress. Additionally, some components of Tier 2 Capital, like subordinated debt, have fixed maturity dates, which can limit their availability when needed.

Applies to:

Tier 2 Capital is primarily applicable to the banking and financial services industry, where regulatory capital requirements are critical for maintaining financial stability and compliance with international banking standards like Basel III.

Doesn't apply to:

Tier 2 Capital does not apply to non-financial industries, as these sectors do not have the same regulatory capital requirements. Non-financial industries focus more on operational metrics and profitability rather than regulatory capital adequacy.

Summary:

Tier 2 Capital serves as a supplementary financial buffer for banks, providing additional security beyond Tier 1 Capital. It is crucial for regulatory compliance and financial stability in the banking sector, although it has limitations in terms of liquidity and availability during financial distress.