Tier 2 and AT1 bank bonds are special kinds of bonds (debt instruments) that banks in India issue to raise money and meet regulatory capital requirements set by the Reserve Bank of India (RBI) under the Basel III norms.
Think of a bank's capital as a safety cushion for absorbing losses. This cushion is divided into different layers, with different levels of risk and loss-absorbing capacity.
AT1 Bonds (Additional Tier 1)
AT1 bonds are the riskiest debt instrument a bank can issue, which is why they usually offer a higher interest rate to investors.
• Role: They form part of the bank's Tier 1 (Core) Capital, the first and most critical cushion for absorbing losses.
• Perpetual Nature: They typically don't have a fixed maturity date (they are "perpetual"). The bank can repay them after a certain period (e.g., five years) but is not obligated to.
• Loss Absorption: This is their key feature. If the bank runs into severe financial trouble, the RBI can force the bank to write off the bond's principal (investor loses the money) or convert it into bank shares (equity) to save the bank.
• Interest Payments: The bank can skip interest payments if its financial position is weak or profits are low.
• Subordination: In the event of a bank failure, they rank just above the bank's equity (shares) but below all other debt, including Tier 2 bonds and deposits.
Tier 2 Bonds
Tier 2 bonds are a less risky form of debt than AT1 bonds, but still riskier than standard bank debt or deposits.
• Role: They form part of the bank's Tier 2 (Supplementary) Capital, which provides a secondary cushion against unexpected losses.
• Maturity: They have a fixed maturity date (typically a minimum of five years).
• Loss Absorption: They also have a loss absorption feature. If the bank hits the official "Point of Non-Viability" (PONV), the RBI can force a write-off or conversion to equity, though they are usually senior to AT1 bonds in this process.
• Interest Payments: Interest payments are generally more assured than on AT1 bonds, though they can still be at risk if the bank is nearing non-viability.
• Subordination: They rank below senior bank debt and deposits but above AT1 bonds and equity in the event of liquidation.
Simple Analogy
Imagine a bank's entire financial structure as a layer cake, where losses start at the top and work their way down:
1. Depositors: They get paid first (usually up to an insured limit).
2. Senior Debt: Other standard loans/bonds.
3. Tier 2 Bonds: They are next in line.
4. AT1 Bonds: They are next, and the first to be fully written off to save the bank.
5. Equity (Shares): The bank's shareholders absorb the final losses.
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