26.Articles 3.3 of the Capital Adequacy Regulation, Tier 2 capital consists of the sum of the following elements:

1. i.Banks using the standardized approach for credit risk: general provisions or general loan loss reserves, up to maximum of 1.25% of credit RWA;
2. ii.Instruments issued by the bank that meet the criteria for inclusion in Tier 2 capital, and are not included in Tier 1 capital;
3. iii.Share premium resulting from the issue of instruments included in Tier 2 capital;
4. iv.Instruments which are eligible for inclusion of Tier 2 (refer to paragraph 27)
5. v.Instruments issued by consolidated subsidiaries of the bank and held by third parties that meet the criteria for inclusion in Tier 2 capital, and are not included in Tier 1 capital;
6. vi.Regulatory adjustments applied in the calculation of Tier 2.

27.The treatment of instruments issued out of consolidated subsidiaries of the bank and the regulatory deductions applied in the calculation of Tier 2 capital are addressed in the Tier Capital Instrument Standard.

Instruments issued by the bank that meet the Tier 2 criteria

28.The objective of Tier 2 capital is to provide loss absorption on a gone-concern basis. Based on this objective, the minimum set of criteria for an instrument to meet or exceed in order for it to be included in Tier 2 capital are set out below.

Criteria for inclusion in Tier 2 Capital

1. i.Issued and paid-in.
2. ii.Subordinated to depositors and general creditors of the bank.
3. iii.Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis depositors and general bank creditors
4. iv.Maturity:
   1. a.minimum original maturity of at least five years
   2. b.recognition in regulatory capital in the remaining five years before maturity will be amortized on an annualized straight line basis (i.e. 20% incremental reduction in recognition every successive year in the last five years)
   3. c.there are no step-ups or other incentives to redeem
5. v.May be callable at the initiative of the issuer only after a minimum of five years:
   1. a.To exercise a call option a bank must receive prior Central Bank’s approval;
   2. b.A bank must not do anything that creates an expectation that the call will be exercised; and
   3. c.Banks must not exercise a call unless:
      1. 1.They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank; or
      2. 2.The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.
6. vi.The investor must have no rights to accelerate the repayment of future scheduled payments (coupon or principal), except in bankruptcy and liquidation.
7. vii.The instrument cannot have a credit-sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organization’s credit standing.
8. viii.Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument or otherwise come into possession of the instrument, such as through receipt of collateral or a reverse repurchase agreement, nor can the bank directly or indirectly have funded the purchase of the instrument.
9. ix.[Applicable for Islamic banks only] If the instrument is not issued out of an operating entity or the holding company in the consolidated group (e.g. a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Tier 2 Capital (Refer to the Capital Instruments Standards).

29.In addition to the criteria outlined above, the instrument must meet the minimum requirements to ensure loss absorbency at the point of non-viability. Please refer to the Capital Instruments Standards.

Share premium resulting from the issue of instruments included in Tier 2 capital

30.Share premium that is not eligible for inclusion in Tier 1, will only be permitted to be included in Tier 2 capital if the shares giving rise to the stock surplus are permitted to be included in Tier 2 capital.
 

General provisions/General loan-loss reserves:

31.Provisions or loan-loss reserves held against future, presently unidentified losses are freely available to meet losses which subsequently materialize and therefore qualify for inclusion within Tier 2. Provisions ascribed to identified deterioration of particular assets or known liabilities, whether individual or grouped, should be excluded. Furthermore, general provisions or general reserves for loan losses will be limited to a maximum of 1.25% of credit risk weighted risk assets calculated under the standardised approach.
 

Capital component of Capital Adequacy Regulation

32.If a bank has complied with the minimum CET1 and Tier 1 capital ratios, the excess AT1 capital can be counted to meet the total capital ratio, also referred to as Capital Adequacy Ratio (CAR).
 

33.Profit-sharing investment accounts must not be classified as part of an Islamic bank’s regulatory capital as referred to in Article 2 of Capital Adequacy Regulation.

34.Investment risk reserves and a portion of the Profit Equalization Reserve (PER), if any, belong to the equity of investment account holders, and thus must not be used in the calculation of an Islamic bank’s regulatory capital. As the purpose of a PER is to smooth the profit pay-outs and not to cover losses, any portion of a PER that is part of the Islamic bank’s reserves must not be treated as regulatory capital as referred to in Article 2 of Capital Adequacy Regulations.