Introduction to Risk-Weighted Assets

What is a risk-weighted asset?

When a bank makes a loan to a customer, for accounting purposes that loan is recorded as an asset on the bank’s balance sheet. Of course, not all customer loans represent the same credit risk for a bank (credit risk being the risk that the customer may default on the loan and not pay it back. For this reason it is also known as default risk). Under international rules for regulatory capital, every loan is assigned a “risk-weighting”, which is meant to reflect the credit risk of the loan, and which is one of the inputs used to determine what the minimum regulatory capital requirement of the bank will be.

In those same regulatory capital rules, there are set directions for determining how much, as a minimum, equity capital a bank is required to have in place. Equity capital is on the other side of the bank balance sheet to assets, it is a liability of the bank. It represents the bank’s owners’ funds, or shareholders’ capital, and the Basel rules state how much as a minimum, shareholders’ funds a bank is required to have.

One of the main drivers of this minimum quantity of capital – but not the sole driver – is the amount of credit risk that a bank has on its balance sheet. And to go back to our first point, the level of the risk of the loan assets depends on how risky the loan customer is. A loan that has been risk-weighted becomes a risk-weighted asset, hence the acronym RWA. The higher the RWA, the more capital a bank will need to have.

How are risk-weightings assigned?

When a bank assesses a new opportunity to lend money to a customer, they conduct an assessment of that asset's riskiness. They take a view on the amount of risk of loss the asset represents and they assign it with a risk weighting.

A low-risk weighting is assigned to low-risk assets, that could be 0% for the UK government or 20% for investment-grade rated banks, and a high-risk weighting is applied to high-risk assets, for example, 100% for the government of a developing economy.

Every loan originated by a bank is assigned a risk weight. This weighting can be the standardised one given by Basel I or Basel II, or it can be one determined by the bank’s own approved internal model. Then the loan amount is multiplied by the risk weighting it has just been assigned, and this now represents the loan amount of riskiness that the asset presents to the bank. This is a useful way to compare different loan opportunities - and critically, these risk weights allow banks to understand how much capital a bank needs to hold against each asset to protect against future losses.

How are risk-weightings applied?

When a bank has analysed all of its assets for their inherent credit risk, and has assigned a risk weighting to every single asset class, and the relevant weightings have been applied to each individual loan, then the bank can now add these all together to come up with a complete view of the total credit risk that sits on their asset balance sheet, in terms of risk-weighted assets. This is the Risk Weighted Asset Base.

It is clear that the total risk-weighted asset base of a bank will be a considerable amount less than the total notional of its lending.

How does risk-weighting influence a bank's capital requirements?

In essence regulatory capital is meant to absorb unexpected losses, while expected losses should be recognised as a cost of doing business.

Risk-weighting influences the regulatory capital requirement by multiplying the RWA base with the minimum required capital ratio, and that determines the capital requirement.

If a bank wishes to use the standardised approach to risk weighting, then we assign the risk weights given by Basel II and which are a function of the credit rating of the loan.

If a bank wishes to use its own internally generated risk weightings, it will need to determine, based on its data, what the EL of each loan is. This is calculated by multiplying together the Exposure at Default, the Loss Given Default and the Probability of Default.

The EL for the loan will imply its risk weighting. This is then used to obtain the RWA for each loan by multiplying it with the loan notional.

Whether one uses a standardised or an internal model approach, one can see that the perceived riskier a bank’s loan book, the more regulatory capital it will need to have in place to enable it to undertake its lending.