An instrument (capital instrument) that belongs to a bank’s tier-2 capital. Tier-2 capital provides an additional source of capital whereby a regulated institution can meet its regulatory requirements in case its core capital (tier-1 capital) falls short of being up to such requirements. This part of capital consists of capital instruments (known as tier-2 capital instruments) that meet the criteria for tier 2 capital and related surplus, additional eligible minority interest, eligible loan loss provisions and regulatory adjustments.

Tier 2 capital instruments are an important component of a bank’s capital structure, particularly as a flexible source of funding that additionally help banks meet regulatory capital requirements. Banks can issue different types of tier 2 capital instruments, such as subordinated debt, preferred stock, CoCos, and tier 2 capital certificates, depending on a bank’s funding needs and risk appetite.

These instruments represents a type of hybrid capital that combines debt and equity features, providing banks with a flexible source of funding. Tier 2 capital is subordinated to tier 1 capital, to the effect that in the event of a bank’s failure, tier 2 capital instruments will absorb losses after tier 1 capital instruments. In this sense, tier 2 capital instruments are riskier than tier 1 capital instruments.

For example, as part of tier-2 capital instruments, contingent convertible bonds (CoCo)- such as contingent capital notes and bail-in bonds, represent hybrid securities that convert into equity in the event of a predefined trigger event (e.g., a drop in the bank’s capital ratio). With their embedded conversion feature, CoCos are considered the riskiest types of such instruments. For that reason, these bonds carry higher yields than other types (subordinated debt and preferred stock).

Furthermore, tier 2 capital certificates constitute a type of capital instrument with a long maturity and a fixed or floating coupon rate. These certificates are similar to subordinated debt but have a lower priority vis-à-vis other debt instruments.