What is Risk-Weighted Asset?
Risk-Weighted Assets is the minimum amount of capital that a bank or other financial institution must hold to cover an unexpected loss arising out of the inherent risk of its assets and doesn’t get bankrupt.
Risk-Weighted Asset Formula
Therefore,
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For eg:
Source: Risk-Weighted Asset (wallstreetmojo.com)
- Tier 1: Capital is a bank’s core capital that is used at times of financial emergency to absorb losses without impact on daily operations. It includes audited revenue reservesRevenue ReservesRevenue Reserve, also known as Retained Earnings, is a reserve type created out of profits that a business generates from its operating activities over a given period. It is used to expand the business operations or to handle contingencies in the long run. read more, ordinary share capital, intangible assetsIntangible AssetsIntangible Assets are the identifiable assets which do not have a physical existence, i.e., you can't touch them, like goodwill, patents, copyrights, & franchise etc. They are considered as long-term or long-living assets as the Company utilizes them for over a year. read more, and future tax benefits.
- Tier 2: Capital is a bank’s supplemental capital that is used to absorb losses at the time of winding up an asset. It includes revaluation reserves, perpetual cumulative preference shares, retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more, subordinated debt, and general provisions for bad debtProvisions For Bad DebtA bad debt provision refers to the reserve made by a company to set aside an amount computed as a specific percentage of overall doubtful or bad debts that has to be written off in the next year.read more.
A bank or a financial institution with a higher Capital Adequacy RatioCapital Adequacy RatioThe capital adequacy ratio measures the bank's financial ability to pay off its obligations. The capital-to-risk weighted assets ratio (CRAR) is evaluated as the percentage of the bank's capital to its risk-weighted assets. Bank's capital is the aggregate of tier 1 and tier 2 capital.read more indicates that it has a sufficient amount of capital to meet unexpected losses. Inversely, when the capital adequacy ratio is low, it indicates that the bank or the financial institutions stand a chance to fail in case of an unexpected loss, which means additional capital is required to be on the safer side. An investor will look to invest in a business that has a higher Capital Adequacy Ratio.
Risk-Weighted Asset Calculation Examples
1) The below table has information regarding Tier 1 and 2 capital for Bank A and Bank B.
It also gives the Capital Adequacy Ratio for these two banks.
| Particulars | Bank A | Bank B |
|---|---|---|
| Tier 1 | 1000000 | 1500000 |
| Tier 2 | 2500000 | 3100000 |
| Capital Adequacy Ratio | 8 | 7 |
Calculation of the Risk-Weighted Assets.
The risk-weighted average can be calculated as below:
2) Bank A has the below portfolio, Calculation of the risk-weighted for the loans (assets)
| Particulars | $ | Risk Weight (%) |
|---|---|---|
| Government Securities | 20000 | 0 |
| Shares | 2000 | 125 |
| Secured Loans | 15000 | 0 |
| Corporate Loans | 50000 | 50 |
| Other Loans | 2000 | 100 |
| Cash Balance | 5000 | 0 |
| Balance with Banks | 1000 | 20 |
| Other Assets | 6000 | 100 |
The risk-weighted asset can be calculated as below:
Advantages
- Ensures that banks and financial institutions have a minimum capital maintainedCapital MaintainedThe capital maintenance concept states that a business's net worth is maintained if net assets at the end of the accounting period are equal to or greater than net assets at the beginning of the period, excluding any withdrawals made during the period.read more to be safe during times of uncertainty.
- Encourages banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more 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
Disadvantages
- 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 IIBasel IIBasel II is the second set of regulations concerning Minimum Capital Requirement, Supervisory Review, Role and Market Discipline, and Disclosure. The Basel Committee on Bank Supervision developed the regulations for international banks in order to ensure a transparent and risk-free banking environment.read more regulatory framework assumes banks to be in the best position to measure their financial risksFinancial RisksFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more, whereas, in reality, they might not be.
- Regulatory requirements have made it mandatory for banks at a global level to follow the Basel framework, which requires additional efforts on the bank’s front. Although the process is streamlined, it requires a lot of manual effort.
Conclusion
- 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.
- It looks at foreseeing potential risks and mitigating the risk as much as possible.
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