Tier 2 capital is a term used to describe particular types of capital held by a bank to meet capitalization requirements. It is less secure than tier 1 capital. Different nations have different laws about capitalization at banks, but generally they must hold capital worth at last 8% of declared assets. If a bank does not meet these requirements, it must take steps to meet them or risk being closed and taken into receivership on the grounds that depositors and investors with the bank are at risk when the bank is undercapitalized.
The types of capital classified as tier 2 capital vary, depending on regional laws and policies. Generally, it includes undisclosed reserves, convertible securities, subordinated debt, and general provisions, capital kept on hand to cover anticipated or future losses. Technically, general provisions may not be capital because they are presumably already accounted for, but since banks may keep funds on hand for losses in the future, they can argue that general provisions are a form of tier 2 capital until they are used.
Capital requirements are set out in the law and banks can be audited to see if they are conforming with the requirements. Proof of assets on hand, as well as assets the bank controls, must be provided on request from regulators. If banks do not have adequate capital, they must be able to explain why. Banks in the process of addressing capital shortfalls will be monitored until the issue is resolved, while banks with no clear plan in place for handling inadequate capitalization can be taken over by regulatory agencies.
Tier 1 capital consists of more stable, dependable form of capital and it is the higher ranking of the two forms of capital a bank can have on hand. Banks usually have a mix of tier 1 and tier 2 capital and should be able to document the capital on hand and how it has been used. Investors and depositors depend on banks to meet capital requirements. If there is a bank run or similar catastrophe, the bank needs to have access to capital to address the problem and keep the bank afloat until conditions stabilize.
In cases where banks fail, their reserves of tier 1 and tier 2 capital are depleted, and depositors, creditors, and investors can make claims against the bank to recover their losses. Things like deposit insurance are designed to minimize risk for people with funds on deposit at the bank.