Risk-Weighted Assets refer to those which are utilized to decide on much capital financial institutions like banks must hold in order to decrease the chances of becoming insolvent. Regulators determine the capital amount required using a complicated risk assessment of every individual kind of asset the bank holds. As a simple example, the loans which have been secured by only letters of credit will be deemed to be far riskier than those loans which are instead backed up by tangible collateral. These would similarly require a greater amount of additional capital than the ones with real collateral.
The concept of Risk-Weighted Assets is relatively new and only dates back to the aftermath of the Global Financial Crisis. At this time following the worldwide financial meltdown from 2007-2009, the banking industry faced stark and rigorous new regulation as a drastic change following the crisis.
The government regulators, spurred on by Congress with their Dodd-Frank banking reform act, came out with massive new and complex capital requirements for the financial institutions in the United States, Great Britain, and Europe especially. As a direct result of this historical phenomenon, today’s banks must hold far greater capital cushion levels than ever before. The dilemma for them is that the accounting rules surrounding these new regulations are extremely complex. Few investors nowadays are able to understand them really, yet they are critically important for investors in banks to grasp.
The central pillar of the revised and still fairly-new calculations is the Risk-Weighted Assets. It would be next to impossible to work out the numbers here, but it is instructive and helpful to concentrate on the general meaning of the idea and to show some examples of how it works generally in practice. Investors can not understand a bank’s balance sheet any longer without having some command of the topic.
Because the 2007-2009 financial crisis occurred mainly as a result of the banks and other financial institutions choosing to heavily back the subprime mortgage home loans, they suffered from massively higher defaults than regulators, investors, and government officials conceived was possible. These massive consumer defaults led to enormous capital sums being lost by the banks, which were too highly leveraged at the time. This caused some of the largest of them to become insolvent. Among these were Washington Mutual Bank (the largest savings and loans institution in history), Wachovia Bank, Bear Stearns, Lehman Brothers, Merrill Lynch, and many more.
So that this problem can be avoided in the future, regulators force every bank now to combine their assets into categories which are similar by asset risk level. The idea is to stop the greedy banks from suffering devastating capital losses again as a single asset class plunges severely in value. Regulators use a few different kinds of tools in order to determine the level of risk for a given category of assets. As a huge percentage of assets the banks hold are loans, the regulators look at the loan repayment sources and the collateral value which underlies them.
For example, commercial building loans generate both principal and interest payments. They do this using income from tenants in the form of lease payments. When buildings are not completely leased out, it is possible that the property manager will be unable to service the loan payments due to a lack of enough regular income. The building itself represents collateral against the loan. The regulators will contemplate the building’s value as part of the determination for Risk-Weighted Assets.
Another example surrounds United States Treasury bonds. These are backed up by the federal governments’ ability to generate taxes. Since these government securities come with a higher credit rating than do the commercial building loans, the regulators will expect less capital to be carried for the bonds than they would for the commercial loans.
Regulators understood these differences in risk levels and so decided that the only sufficient way to guarantee sufficient capital for a bank is to make them vary their capital requirements according to the risk they were taking with different types of assets. This is how the risk-weighted assets came into being in the first place.