Risk-Weighted Asset

Article byAbhilash Ramachandran
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Risk-Weighted Asset?

Risk-Weighted Assets are 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 not get bankrupt. Risk-Weighted Asset calculation enables a comparison between two different banks operating in two different regions or countries.

Risk-Weighted-Assets

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Basel Committee on Banking Supervision has formulated the Basel Accord that provides recommendations on risks related to banking operations. These accords, namely, Basel IBasel IBasel I, also known as the 1988 Basel accord, is a standard set of banking regulations on minimum capital requirements for banks that are based on specific percentages of risk-weighted assets with the goal of minimizing credit risk.read more, Basel II, and Basel IIIBasel IIIBasel III is a regulatory framework designed to strengthen bank capital requirements while also mitigating risk. It is an extension in the Basel Accords, designed and agreed upon by members of the Basel Committee on Banking Supervision.read more, is to ensure that banks and financial institutions have the required amount of capital to absorb the unexpected losses.

Risk-Weighted Asset Explained

Risk-weighted assets, commonly abbreviated as RWAs, represent a method for evaluating the potential financial risk associated with a bank’s assets. This assessment is essential for determining the amount of capital a financial institution needs to hold as a buffer against unforeseen losses. It is known for embodying the prudent approach financial institutions adopt to assess and manage risk.

The calculation of the risk-weighted asset ratio involves assigning varying risk weights to different categories of assets based on their perceived risk levels. Higher-risk assets, such as loans to less creditworthy borrowers, receive higher risk weights, necessitating a greater allocation of capital to cover potential losses. Conversely, lower-risk assets, like government bonds, carry lower risk weights, requiring less capital.

Regulatory bodies, such as central banks, often mandate financial institutions to maintain a minimum level of capital adequacy in relation to their risk-weighted assets. This regulatory framework, known as Basel III, aims to enhance the stability of the global banking system by ensuring that banks possess sufficient capital to withstand financial shocks.

By employing the risk-weighted assets framework, financial institutions can more accurately reflect the potential risks in their portfolios, fostering a more resilient and stable banking sector. This approach not only safeguards the interests of depositors and investors but also contributes to the overall health and integrity of the financial system, reinforcing trust in the markets. In essence, understanding risk-weighted assets is integral to comprehending how financial institutions prudently manage risk and maintain a robust financial foundation.

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Formula

Let us understand the formula that shall act as the very basis for risk-weighted asset calculation through the detailed discussion below.

Capital Adequacy Ratio = Tier 1 Capital + Tier 2 Capital / Risk-Weighted Assets

Therefore,

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 sufficient 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 of failing in case of an unexpected loss, which means additional capital is required to be safer. An investor will look to invest in a business with a higher Capital Adequacy Ratio.

Examples

Now that we understand the intricacies of risk-weighted asset ratio, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

The below table has information regarding Tier 1 and 2 capital for Bank A and Bank B.

You can download this Risk-Weighted Asset Excel Template here – Risk-Weighted Asset Excel Template

It also gives the Capital Adequacy Ratio for these two banks.

ParticularsBank ABank B
Tier 110000001500000
Tier 225000003100000
Capital Adequacy Ratio87

Calculation of the Risk-Weighted Assets.

The risk-weighted average can be calculated as below:

Risk-Weighted Asset Example 1-1

Example #2

Bank A has the below portfolio, Calculation of the risk-weighted for the loans (assets)

Particulars$Risk Weight (%)
Government Securities200000
Shares2000125
Secured Loans150000
Corporate Loans5000050
Other Loans2000100
Cash Balance50000
Balance with Banks100020
Other Assets6000100

The risk-weighted asset can be calculated as below:

Example 1-3

Advantages

Let us understand the advantages of risk-weighted asset calculation through the points below.

Disadvantages

Despite the various advantages mentioned above, there are a few factors of the risk-weighted asset ratio that prove to be a disadvantage. Let us understand them through the explanation below.

This has been a guide to What is Risk-Weighted Asset. We explain the formula to calculate risk-weighted assets with examples, advantages, and disadvantages. You can learn more about excel modeling from the following articles –