Basel Committee

• The Basel Committee, an international organization of financial regulators, is made up of members from a number of countries, including Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the U.S. Although the committee holds no legal authority, many of the international banks around the world in more than 100 countries adhere to the Basel standard guidelines. Tier 3 bonds are one means of following these standards.
  
  

Understanding Tier 3

• Under the Basel Committee recommendations, a financial institution should hold an 8 percent minimum in capital of the institution's risky assets. International banks and financial institutions to meet capital requirements use tier 3 bonds, also called third tier capital or tertiary capital. Tier 3 bonds are generally short-term subordinated debt obligations of the issuer and have no creditor protection. In other words, no collateral or guarantee backs the debt.
  
  

Subordinated Debt

• A subordinated debt means it is of lesser rank or less important than other debt. For example, if a bank uses tier 3 bonds to meet capital requirements, other claims on assets such as deposit accounts and senior debt would rank higher. Thus, in the event of bankruptcy, tier 3 bondholders would hold a subordinated claim on assets compared to depositors and investors in senior debt. In the event of liquidation of the financial institution, creditors holding tier 3 bonds rank below senior bonds but above tier 2 bonds and tier 1 bonds. All bondholders rank above shareholders and investors holding equities or stock in the company.
  
  

Contract Provisions

• The original maturity on tier 3 bonds is commonly three to five years, with a minimum of two years. Tier 3 bond contracts carry a lock-in clause, which means if the financial institution's capital requirements dip below the required minimum, neither interest nor the principal will be paid on a tier 3 bond, regardless of whether the bond matures or not. Many banks also establish a cap on the amount of tier 3 debt that may be issued.
  
  

Investor Interest

• The price of tier 3 bonds is volatile due to the higher default risk, which can translate into moderate profits or moderate losses. Investors are interested in tier 3 bonds because of the potential of returning higher yields than senior bonds. As with the majority of bond investments, buyers require a higher interest rate to purchase higher risk bonds.