What Are Risk-Weighted Assets?
Risk-weighted assets (RWA) are used to determine the minimum amount of capital that must be held by banks and other financial institutions in order to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset.
For example, a loan that is secured by a letter of credit is considered to be riskier and, thus, requires more capital than a mortgage loan that is secured with collateral.
Risk-weighted assets are used to determine the minimum amount of regulatory capital that must be held by banks to maintain their solvency. This minimum is based on a risk assessment for each type of bank risk exposure: credit, market, operational, counterparty and credit valuation adjustment risks. The riskier the asset, the higher the RWA and the greater the amount of regulatory capital required.
Understanding Risk-Weighted Assets
Risk-weighted asset (also referred to as RWA) is a bank’s assets or off-balance-sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. In the Basel I accord published by the Basel Committee on Banking Supervision, the Committee explains why using a risk-weight approach is the preferred methodology which banks should adopt for capital calculation:
- it provides an easier approach to compare banks across different geographies
- off-balance-sheet exposures can be easily included in capital adequacy calculations
- banks are not deferred from carrying low risk liquid assets in their books
Usually, different classes of assets have different risk weights associated with them. The calculation of risk weights is dependent on whether the bank has adopted the standardized or IRB approach under the Basel II framework.
Some assets, such as debentures, are assigned a higher risk than others, such as cash or government securities/bonds. Since different types of assets have different risk profiles, weighting assets according to their level of risk primarily adjusts for assets that are less risky by allowing banks to discount lower-risk assets. In the most basic application, government debt is allowed a 0% “risk weighting” – that is, they are subtracted from total assets for purposes of calculating the CAR.
A document was written in 1988 by the Basel Committee on Banking Supervision which recommends certain standards and regulations for banks. This was called Basel I, and the Committee came out with a revised framework known as Basel II. The main recommendation of this document is that banks should hold enough capital to equal at least 8% of its risk-weighted assets. More recently, the committee has published another revised framework known as Basel III. The calculation of the amount of risk-weighted assets depends on which revision of the Basel Accord is being followed by the financial institution. Most countries have implemented some version of this regulation.
When calculating the risk-weighted assets of a bank, the assets are first categorized into different classes based on the level of risk and the potential of incurring a loss. The banks’ loan portfolio, along with other assets such as cash and investments, is measured to determine the bank’s overall level of risk. This method is preferred by the Basel Committee because it includes off-balance sheet risks. It also makes it easy to compare banks from different countries around the world.
Riskier assets, such as unsecured loans, carry a higher risk of default and are, therefore, assigned a higher risk weight than assets such as cash and Treasury bills. The higher the amount of risk an asset possesses, the higher the capital adequacy ratio and the capital requirements. On the other hand, Treasury bills are secured by the ability of the national government to generate revenues and are subject to much lower capital requirements than unsecured loans.
Setting Rules for Risk Weighting
The Basel Committee on Banking Supervision (BCBS) is the global banking regulator that sets the rules for risk weighting. The first step in international banking regulation started with the publication of the Basel I framework, which set the capital requirements for banks. It was followed by the Second Basel Accord of 2004 that amended the banking regulations on the amount of capital banks should maintain against their risk exposure. Basel II recommended that banks should hold adequate capital that is at least 8% of the risk-weighted assets.
The financial crisis of 2007/08 exposed the inefficiencies that existed in the banking industry that led to the collapse of large US banks. The main cause of the crisis was investments in sub-prime home mortgage loans that carried a higher risk of default than bank managers expected – or at least acknowledged.
Following the global financial crisis, the BCBS introduced the Basel III framework, which aimed to strengthen the capital requirements of banks. It also established new requirements for funding stability and liquid assets. Basel III requires banks to group their assets by risk category so that the minimum capital requirements are matched with the risk level of each asset. The framework is scheduled to take full effect on January 1, 2022.
How to Assess Asset Risk
When determining the risk attached to a specific asset held by a bank, regulators consider several factors. For example, when the asset being assessed is a commercial loan, the regulator will determine the loan repayment consistency of the borrower and the collateral used as security for the loan.
On the other hand, when assessing a loan used to finance the construction of coastal condominiums, the assessor will consider the potential revenues from the sale (or rental) of the condos and if their value is sufficient to repay the principal and interest payments. This is assuming that the condos serve as collateral for the loan.
If the asset being considered is a Treasury bill, the assessment will be different from a commercial loan, since a Treasury bill is backed by the government’s ability to continually generate revenues. The federal government has higher financial credibility, which translates to lower risk to the bank. Regulators require banks holding commercial loans on their balance sheet to maintain a higher amount of capital, whereas banks with Treasury bills and other low-risk investments are required to maintain far less capital.
Capital Requirements for Risk-Weighted Assets
Capital requirements refer to the minimum capital that banks are required to hold depending on the level of risk of the assets they hold. The minimum capital requirements set by regulatory agencies such as the Federal Reserve and the Bank for International Settlements (BIS) are designed to ensure that banks hold enough capital, proportionate to the level of risk of the assets they hold. The capital acts a cushion of cash if the bank incurs operational losses in the course of the operations.
- Ensures that banks and financial institutions have a minimum capital maintained to be safe during times of uncertainty.
- Encourages banks and financial institutions to review their current financial condition and puts highlights any red flags in case of minimum capital requirement.
- As per the Basel Committee on Banking Supervision, it helps banks in achieving capital adequacy goals.
- It reduces the risk of foreseeable risks
- It is backward-looking, meaning; it assumes that security that has been risky in the past is the same as the securities that are going to be risky in the future.
- Banks are required to hold more common stocks since it needs to find less risky assets with returns.
- The Basel II regulatory framework assumes banks to be in the best position to measure their financial risks whereas, in reality, they might not be.
- Regulatory requirements have made it mandatory for banks at a global level to follow Basel framework which requires additional efforts on the bank’s front.
- Although the process is streamlined it requires a lot of manual efforts.
- Risk-Weighted Asset is the amount of capital that a bank or a financial institution needs to maintain to cover an unexpected loss arising out of the inherent risk of its assets.
- Basel Committee on Banking Supervision has formulated the Basel Accord that provides recommendations on risks related to banking operations. The aim of these accords, namely, Basel I, Basel II and Basel III is to ensure that banks and financial institutions have the required amount of capital to absorb the unexpected losses.
- Risk-Weighted Asset enables a comparison between two different banks operating in two different regions or countries.
- A high risk-weighted asset means the assets held are risky and would require a higher capital to be maintained.
- A low risk-weighted asset means the assets held are less risky and would require lower capital to be maintained.
- Risk-weighted asset looks at foreseeing potential risks and mitigating the risk as much as possible.