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,
- 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 reserves, ordinary share capital, intangible assets, 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 earnings, subordinated debt, and general provisions for bad debt.
A bank or a financial institution with a higher Capital Adequacy Ratio 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.
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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)
The risk-weighted asset can be calculated as below:
Advantages
- 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
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 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 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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