The past year has seen an increasing number of hybrid capital issues from Australian banks, sometimes pitched at retail investors and some pitched at wholesale investors. Sometimes these issues constitute Tier 1 capital and sometimes they constitute Tier 2 capital. The following is a guide to understanding the basic differences between these two types of capital and how each has a distinct place on the capital ladder.
Background
Every regulated bank in Australia has to maintain a certain level of regulatory capital that is calculated as the sum of its Tier 1 and Tier 2 capital, net of all specified deductions.
Tier 1 capital
Tier 1 capital is made up of those assets that a bank can use to meet its short term obligations most easily without triggering a bankruptcy event. These assets typically include ordinary shares and retained earnings and make up most of the Tier 1 capital held by Australian banks. Tier 1 capital also includes certain types of preference shares and convertible securities. Since it is harder for banks to allocate losses to such securities, APRA says that no more than 25 per cent of Tier 1 capital can be in this form.