What is a Risk-Weighted Asset?

Risk-Weighted Asset Formula

Therefore,

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  • Tier 1: Capital is a bank’s core capital used at times of financial emergency to absorb losses without impacting 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 additional capital used to absorb losses when 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 debtSubordinated DebtIn case of liquidation of a company, rankings are provided to various debts for repayment, wherein the kind of debt which is ranked after all the senior debt and other corporate Debts and loans is known as subordinated debt, and the borrowers of such kind of debt are larger corporations or business entities.read more, 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 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.

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.

Calculation of the Risk-Weighted Assets.

The risk-weighted average can be calculated as below:

  1. 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 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 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 highlights any red flags in case of minimum capital requirement.The Basel Committee on Banking Supervision helps banks achieve 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 will be risky in the future.Banks must hold more common stocks since they need 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. 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 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 them as much as possible

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

  • Definition of Risk TransferRisk-Reward RatioHeadline InflationOperational Risks Definition