Risk Weighted Assets - An overview

Risk-weighted assets ("RWA") is one of the most important concepts to learn in finance.

Overview:

The general idea is that when banks lend money to borrowers, there is a risk of default by the borrowers. These loans are labelled as an asset because when banks lend to borrowers, these appear on the bank's balance sheet as an asset (think receivables). RWA is thus basically the bank's asset whose nominal value is adjusted for its riskiness, converting it into a standardised measure of risk exposure. The higher the risk, the higher the potential loss and hence the higher its RWA. Itself, RWA is a function of exposure at default (EAD), probability of default (PD), and loss given default (LDG).

The reason RWA is crucial is that banks must hold a certain amount of capital against their RWAs to be able to absorb potential losses in the event of default and protect depositors and the financial system in general. This amount is dictated by the Capital Adequacy Ratio ("CAR") requirements.

CAR:

There are 3 key components to the CAR formula: 

1) CAR - the minimum ratio is regulated by the government / central bank.

2) RWA - calculated risk exposure by the bank in accordance with guidelines by the regulators.

3) Capital - the minimum capital that a bank must hold for its total RWA to meet regulatory requirements. This capital primarily comprises tier 1 (Common Equity Tier 1 (CET1) capital and Additional Tier 1 (AT1) capital) and Tier 2 capital.

*I will go into the different forms of capital in a separate post. 

Putting these together, with higher RWA and a fixed CAR, the amount of capital a bank must have is higher. This presents several challenges for the bank, including:

1) Opportunity Cost - minimum capital that must be held by the bank, thus unable to be deployed for other income-generating purposes.

2) Profitability / Growth - lower Return on Equity (ROE) assuming profits stay the same, given the higher equity base. The bank would then be less attractive to investors and potentially impede overall balance sheet growth (e.g. through higher cost of equity, difficulty raising more capital etc.).

Three scenarios to note:

1) RWA for hedging: While derivatives like FX swaps, interest rate swaps (IRS), and secured swaps are used to hedge risk, they still generate RWA. This is because the RWA generated is from the counterparty's credit risk when the hedge is executed, not the risk of the underlying itself. However, this is typically very low, especially if the counterparty is investment grade.

2) Increasing RWA: In theory, RWA should decrease over time for a given amortising loan as the principal owed to the bank and correspondingly the risk reduces. However, there are instances when RWA increases over time (not exhaustive):

a) Decrease in credit quality of the borrower, e.g. during periods of financial distress, hence increasing their probability of default and RWA.

b)  Changes in regulations, such as increasing the risk weights of certain types of loans by the regulators, may also result in a higher RWA.

3) RWA higher than principal: This is possible when the risk weighting assigned to a particular asset/loan is >100% of the principal amount. Such high-risk assets include those with high volatility, speculative exposures, subordinated debt, and low credit standing. 

Quick check: why is it possible for RWA to be greater than the principal if the principal is the max exposure / possible loss of the bank? The reason goes back to the notion of RWA - it is not the maximum amount of loss, but rather the amount of capital a bank must hold to buffer against potential losses. In the case of risky assets, this buffer must be higher. This not only provides a greater safety margin for such unexpected losses, but also denotes a disincentive for banks to take excessive risk.

Diving further, let's break down RWA. Total RWA comprises RWA from credit risk, market risk and operational risk.

1) Credit risk: the risk that a borrower will not repay the loan. Certain banks use the internal risk-based approach ("IRB"), where instead of using fixed risk weights, it uses its own models to determine the riskiness based on probability of default (PD), loss given default (LGD), exposure at default (EAD) and maturity. 

2) Market risk: risk of losses from changes in market prices (interest rate, exchange rate, stock prices) for a bank's trading book.

3) Operational risk: risk of losses from internal errors or external events (e.g. fraud).

From the bank's perspective, we focus on credit risk RWA which is given by the formulas:

• RWACredit Risk (IRB)​=EAD×RWcalculated from PD, LGD, M​
• RW ≈(Unexpected Loss Probability×LGD)×Scaling Factor
• Where Scaling Factor = ~9.5 based on the 10.5% minimum capital adequacy ratio under Basel III.

In the event of high EAD, PD, and LGD, in conjunction with the scaling factor, RW may increase > 100% and hence if EAD = 1, RWA will be greater than the total loan amount.