Under the CRD IV regulatory package, EU banks have to fulfill certain capital requirements, which are grouped inter alia as Tier 1 and Tier 2 financial instruments. Tier 1 instruments constitute the ‘going-concern capital’ of the financial institution, while Tier 2 instruments form the ‘gone-concern capital’. This means that Tier 1 instruments may absorb losses of the institution on an ongoing basis, while Tier 2 instruments absorb losses when a financial institution becomes insolvent or faces liquidation. The core of this system is an instrument known as the Common Equity Tier 1 (CET1). A CET1 must be composed of the highest quality of capital and possess maximum loss-absorption capacity. CET1 instruments are mainly common shares and retained earnings, while hybrid bonds may be assigned to either the category of Additional Tier 1 (AT1) or that of Tier 2 (T2), provided that certain criteria are met. These criteria also may be classified in a manner reflecting the aforementioned dimensions of the debt–equity continuum (Figure 4.1).
KeywordsEuro Area Capital Requirement Equity Continuum Preference Share Contagion Risk
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