What Are Risk-Weighted Assets, and Why Do They Matter to Bank Investors?

RISK-WEIGHTED ASSETS (RWA) (ENCYCLOPEDIA)

Risk-weighted assets are used to determine the minimum amount of regulatory capital that must be held by banks to maintain their solvency. This minimum is based on a risk assessment for each type of bank risk exposure: credit, market, operational, counterparty and credit valuation adjustment risks. The riskier the asset, the higher the RWA and the greater the amount of regulatory capital required.

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Risk-weighted assets (RWA) represents an aggregated measure of different risk factors affecting the evaluation of financial products. All the risk components are considered together to “correct” the nominal value of financial assets. In this way, a proper measure of the extent to which the underlying risk is increasing or decreasing the accounting value of financial assets is generated. This assessment attributes a high weight-coefficient to high-risk financial assets, and a low-weight coefficient to low-risk ones. For example, let’s consider two financial assets with the same nominal value:

— a corporate bond with a medium/long-term duration of a company presenting negative losses during the last three years, and a BBB rating;
— a sovereign bond with a short-term duration of a country presenting a low systemic risk, and a AAA rating.

Hence, the first financial asset will produce higher RWA compared to the second one.

As the Basel Committee points out, RWA play a very important role in the banking sector,  helping banks monitoring their efforts in achieving capital adequacy goals (see Basel I1, Basel II2, Basel III3). RWA quantification affects the amount of capital the bank will have to retain to be compliant with the imposed capital adequacy requirements. This amount, which cannot be invested in risky projects, will be indeed a non-interest bearing money-sum. In light of this, banks have arranged internally RWA monitoring and reduction strategies to contain risk, e.g., to minimize expenses on otherwise greater capital provisions. These strategies, which mainly focus on the improvement of asset quality, imply the choice of those counterparties showing the lowest risk profile for a given level of return on investments.

Major risk components of the RWA calculation are Credit risk, Market risk, and Operational risk.4 Assets, weighted by these components and taken altogether, represent the RWA.

Assuming a lender and a borrower, Credit risk can be seen as the borrower-default risk (counterparty risk), taking place when the he is no longer solvent, i.e., when he is not able to return money back. This risk could relate to the interest rate-quota of the loan, to the capital-quota, or both. Credit risk generates from every financial transaction and weighs on the lender, whatever the technical form of the loan is (e.g., a mortgage loan granted to buy a house, a credit card, a personal loan, or a credit line provided to a company to finance its productive activity).

Other two risks can be included into the broader category of credit risk. The first refers to the risk that the borrower delays his payments related to both interest and capital quotas (i.e., Past-due credit risk). The second, refers to the so called Country risk, applying when the borrower operates in a country with a high systemic risk. In this case, the lender may suffer from foreign currency problems.

Generally, the lender implements actions to reduce credit risk. For example, he may want to incorporate the risk directly into the transaction price (risk-based pricing) which consequently increases to account for borrower’s probability of default. Similarly, he can also ask for transaction collaterals, or he can eventually buy an insurance policy to protect himself from the credit risk (credit default derivatives). Despite all these possibilities, if the lender evaluates that he is not sufficiently covered against credit risk, then negative effects on lending activity could arise, such as credit crunch effects, resulting in either the provision of a smaller amount of money to the borrower vis-à-vis the required amount, or the request for a higher collateral.

Market risk is represented by the probability that the value of a financial asset, traded on a sufficiently liquid marked, changes due to not predictable market factors. These factors can be linked to the uncertainty connected to some financial indicators such as the interest rates (e.g. Euribor and Libor), the spread between risky and risk-free government bonds, exchange rates, and real indicators like inflation or unemployment rates. Typically, risk market evaluation aims to quantify the unexpected loss for a financial asset, by using ad hoc models (e.g., Value at Risk models). These models quantify the maximum potential loss, to which a confidence interval applies, that can be generated by the above-mentioned market factors during a specific time horizon.

The Basel Committee defines Operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events”.5 In other words, it represents the probability that the value of a financial asset is influenced by unpredictable factors, resulting from running the bank activity. Bank employees can incur into calculation errors, or into procedural blocks that could temporarily prevent the correct execution of financial transactions (business disruption {amp}amp; systems failures, execution, delivery {amp}amp; process management mistakes). On the other hand, they can face internal and external fraud problems or robberies causing a loss in financial resources. Other risks belonging to this category involve all legal issues (clients, products, {amp}amp; business practice), as well as the loss of physical goods underlying any transaction (damage to physical assets).

Like market risk, a proper evaluation of operational risk is provided by advanced statistical models. Among others, the AMA — Advanced Measurement Approaches6 — is perhaps the most diffused model type and bases on the modelling of all the events from which operational risks derive. This is done by first collecting frequency data and by considering variables with a predictive power in terms of future incident occurrence. The final aim is that of evaluating the size of operational risks to be included into the RWA calculation, and mitigate therefore the risk as much as possible.
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1http://www.bis.org/list/bcbs/tid_21/index.htm
2http://www.bis.org/list/bcbs/tid_22/index.htm
3http://www.bis.org/bcbs/basel3.htm
4However, in the RWA regulation also other minor risk components are contemplated: in particular, also RWA generated by securitization exposure risks have to be considered, and other less relevant types of RWA. For a more complete detail of different risk types to consider into the RWA calculation, see Basel III official regulation and FAQs. http://www.bis.org/bcbs/qis/qiscompfaq.pdf
5http://www.riskglossary.com/link/operational_risk.htm
6http://www.federalreserve.gov/generalinfo/Basel2/docs2003/ama_implementation.pdf

Editor: Melania MICHETTI

What Are Risk-Weighted Assets, and Why Do They Matter to Bank Investors? | The Motley Fool

House balanced on risk

Image source: Getty Images.

One of the most dramatic changes to the banking industry since the financial crisis is the rollout of new capital requirements for banks. Banks today are required to hold higher levels of capital, dictated by complex accounting rules that very few investors truly understand. 

A central part to this new calculation is a concept called risk-weighted assets. In its minutiae, calculating a bank’s risk-weighted assets is a nightmare. We won’t do that here. Instead we’ll focus on what it means more generally, and why that understanding is really important to understanding a bank’s balance sheet.

Capital, risk-weighted assets, and a potentially bad headache
I don’t think anyone would argue that a bank shouldn’t be required to maintain certain capital levels on its balance sheet. That capital protects the bank from losses and ultimately protects taxpayers from potentially expensive bailouts. How to regulate that capital level though is a bit more complex.

The simplest approach would be to require all banks to maintain a maximum leverage ratio — something like the assets-to-shareholder equity ratio. It would be simple, everyone could understand it, and there would be no question which banks were overly leveraged.

The problem with the simple ratio approach is that it leaves a not-so-obvious gap on the asset side of the balance sheet. Consider two hypothetical banks, both with $50 billion in total assets.

Bank A has 50% Treasuries, 25% loans, 15% in branches and buildings, and 10% in cash. That’s a pretty conservative balance sheet. Bank B though could have 50% in loans, 29% in weird derivatives, 20% in branches, and 1% in cash. That’s a whole lot more risk. 

Using the assets-to-shareholder equity approach, Bank B would in theory have the same capital requirement as Bank A, even though it is so clearly a more risky institution. That simple approach doesn’t recognize that a subprime loan is more risky than a U.S. T-Note.

Regulators recognized this and concluded that the best way to guarantee that a bank has adequate capital is to force banks to take that varying risk into account. And thus, risk-weighted assets were born.

How it works, in practice
Using fancy accounting models far outside the scope of this article, banks and regulators calculate exactly how risky each asset set is and then determine an appropriate level of capital that must be available to back that asset. Even many off balance sheet items carry a risk weighting, like the available credit on your home equity line of credit as an example.

Let’s break it down with another example. Cash and Treasuries, we agree, have little if any risk. Therefore, banks could reasonably assign them no risk and reserve no capital. A subprime loan that is 90 days past due on its payments, however, may require a capital reserve of 50% or more.

Banks go through this process for the entire asset side of the balance sheet and add up all the capital required based on the assigned risk weightings. That sum is the minimum required capital level for that bank.

The implication for return on equity, and why this matters a lot for bank investors
A byproduct of this framework is a new game for reaching return on equity objectives. With capital requirements explicitly linked to risk, we as investors must up our game to understand exactly how management constructs the asset side of the balance sheet.

On one hand, a bank can pile into highly rated corporate bonds — low-yielding assets that require little capital reserves. Or perhaps the bank chooses highly rated sovereign debt, which also carries a low risk rating and therefore a lower capital requirement. Even with the very low yields available in these assets, the low capital requirements make the return-on-equity proposition attractive.

But what would happen if there was a bear market in corporate bonds? Or if a global economic crisis, like the current oil issues plaguing Russia, suddenly put those foreign assets at risk? Or worse yet, what if all banks bought in and unknowingly drove a bubble in these seemingly safe assets?

Banks that attempt to game return on equity could very easily find themselves overconcentrated on a certain asset — one that may have been deemed as «safe» just before it wasn’t. Investors, beware; these risks are real.

Foolish takeaway
The solution for the bank investor is to make sure that you fully understand what assets the bank actually holds, at least as much as is possible. I recommend using the bank’s regulatory filings known as «call reports«. You can compare that with the rest of the industry using the FDIC’s Quarterly Banking Profile.

Ask yourself: Is the bank holding an abnormal level of cash, Treasuries, or other asset type? If so, make sure you understand why. Is the bank overweight in a specific loan type like commercial real estate? If so, are you comfortable with the bank’s expertise and experience in that arena? Do you understand what each asset is, how it helps the bank earn, and what risk comes with it?

Your best bet is to find banks with diversified earning assets coupled with efficient operations. Those banks will have plenty of earnings, without unnecessary concentrations or risky assets, and they will have the efficiency to ensure that the profits and returns take care of themselves.

Risk-weighted assets (RWAs) are a way of measuring a bank’s assets according to their different levels of risk. Safe mortgages, speculative loans and holdings in complex derivatives will all carry a different risk weighting.

The risk-weighted assets metric replaced more simple measures of assets to equity. Before, two banks could have held the same dollar number of assets and therefore had the same capital requirements, but one bank could have held a far riskier portfolio than the other.

After 2008, regulators realised this was a serious issue and introduced the varying risk of assets in a portfolio into the capital requirement calculations. If you’re invested in banking stocks, you should be aware of exactly what assets they hold and how risky they are.

Jeffrey Glen

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Where have you heard about risk-weighted assets?

The use of risk-weighted assets as a measure of a bank’s overall capital at risk has grown significantly since the financial crisis of 2008. Under the Basel III capital accord regulations, banks must have top quality capital equivalent to at least 7 per cent of their risk-weighted assets.

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