Meaning
The calculated value of a bank’s assets adjusted for risk determines the minimum amount of regulatory capital the institution must hold to remain solvent. Regulatory bodies use risk weighted assets to measure a bank’s exposure to credit, market, and operational risks. This capital calculation applies to both on-balance sheet assets and off-balance sheet commitments.
Capital Adequacy
Under the Basel Accords, banks must maintain a minimum capital ratio relative to their total risk exposure. Managing risk weighted assets allows a bank to optimize its capital structure and return on equity.
Risk Calculation
Financial analysts use standardized or internal model approaches to assign risk weights to different asset classes. Cash and government bonds have a zero percent risk weight, whereas commercial loans carry a higher risk weight. The calculated sum of these weighted exposures represents the total risk weighted assets of the financial institution.
This total is used to calculate the tier-one capital ratio. Tax and regulatory audits ensure that the models used to calculate these weights are accurate and unbiased.
Portfolio Optimization
Banks adjust their lending portfolios to reduce high-risk exposures and lower their regulatory capital requirements. This strategic management of risk weighted assets helps banks maintain liquidity during economic downturns. It prevents the bank from becoming insolvent due to excessive credit defaults.
