Risk Weighted Assets is more of a concept than an asset. When a bank lends money, there is a chance some of it will not be paid back. The “some” that might not be paid back is the RWA. The Capital Adequacy Requirement (CAR) requires banks to maintain a Risk-Based Capital Ratio. This is a simple calculation of dividing Regulatory Capital with RWA. Regulatory Capital is the amount of Tier 1 and 2 capital a bank is required to possess at all times. Ideally, a bank would like to have a high Regulatory Capital and low RWA. The risk weights inflate bank assets. While larger assets are considered a good thing on the balance sheet, generally, in this case it is not. RWA valuation is not used to meet the SEC filing requirements. It is used to meet the Basel III requirements. There are 26 classifications of assets with varying risks. Each classification requires the bank to multiply assets by a Basel II prescribed risk weight.
Conceptually, here is what RWA looks like:
The bank lends $100 to a borrower. This particular type of loan with this type of borrower has a significant chance of getting but just $95. Because the risk of lose if $5, the $100 is multiplied by 105%. For this $100 loan, it is a $105 RWA. Banks are required to hold 1/10 in the Risk-Based Capital Ratio. Without the RWA, the bank would have to hold $10 (1/10=$10/$100). But since the $100 is being changed to an RWA of $105, the bank now has to hold $10.50 (1/10=$10.5/$105).
About the Author: Marcus Maltempo is a compliance professional with more than a decade of experience helping banks, law firms and clients manage investigations and regulatory responses.