Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution. In the Basel I accord published by the Basel Committee on Banking Supervision, the Committee explains why using a risk-weight approach is the preferred methodology which banks should adopt for capital calculation.
It
provides an easier approach to compare banks across different geographies off-balance-sheet
exposures can be easily included in capital adequacy calculations banks are not
deterred from carrying low risk liquid assets in their books
Usually,
different classes of assets have different risk weights associated with them.
The calculation of risk weights is dependent on whether the bank has adopted
the standardized or IRB approach under the Basel II framework.
Some
assets, such as debentures, are assigned a higher risk than others, such as
cash or government securities/bonds. Since different types of assets have
different risk profiles, weighing assets based on the level of risk associated
with them primarily adjusts for assets that are less risky by allowing banks to
discount lower- risk assets. In the most basic application, government debt is
allowed a 0% "risk weighting" - that is, they are subtracted from
total assets for purposes of calculating the CAR.
For
banks, risk-weighted assets are assets with special risks, especially loans to
customers and other financial institutions or governments, weighted according
to different levels of possible default. As risk is calculated differently for
each type of loan, Basel II set out a procedure of determining the different
risk levels. For example, government bonds with a rating over AA – are weighted
as zero percent, whereas corporate loans with the same ratings are weighted at twenty
percent. These rules also take into account
the credit risk, operational risk and market risk of the loans. Other factors
must be considered as well when determining risk. For example, a loan secured
by a letter of credit would be weighted as riskier than one secured by
collateral.