Risk-weighted assets are those held by a bank or other financial properties that are weighted according to their risk level. This system of determining the riskiness of the assets is used by the Federal Reserve Board in the United States to determine how much capital a bank must have on hand at any time to prevent a financial failure. A bank must contain capital that measures out to a predetermined percentage of its risk-weighted assets. Each asset is assigned a risk weight that is based on the amount of risk involved.
The use of risk-weighted assets to determine the minimum amount of capital required for banks represents a shift away from static requirements. It stands to reason that a bank that has is well-stocked with cash is more financially sound than one heavily reliant on loans and credit. This system helps to prevent a bank from taking on more risks than it is able to cover should some of its less-stable ventures fail.
In a system of risk-weighted assets, certain assets are assigned a risk weight that is multiplied by the actual value of the asset on hand. Letters of credit, or debentures, and ordinary loans each have a risk weight of 1.0, while mortgage loans are at 0.5 and loans between banks are at 0.2. Cash and government securities have no risk weight because there is no risk attached to these assets.
For example, Bank A has letters of credit worth $2,000 U.S. Dollars (USD), ordinary outstanding loans of $500 USD, mortgage loans of $600 USD, and interbank loans valued at $1,000 USD. Using the risk weights in accordance with these values, $2,000 USD is multiplied by 1.0 to get $2,000 USD. The $500 USD is also multiplied by 1.0 to get $500 USD, $600 is multiplied by 0.5 to get $300 USD, and $1,000 USD is multiplied by 0.2 to get $200 USD. Adding all of these totals together gives Bank A a total of $3,000 in risk-weighted assets.
Using this total determines the amount of capital a bank must have on hand to cover this risk. According to U.S. Federal Reserve Board regulations, Tier 1 capital, which is the value of a bank's stock added to its retained earnings, must add up to 4 percent of the risk-weighted assets. Total capital, which includes subordinated debt, loan-loss reserves and Tier 1 capital, must add up to 8 percent of those assets. In the example above, Bank A would have to have Tier 1 capital equaling $120 USD and total capital of $240 to offset its risks.
