Risk-Weighted Assets

Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks and other institutions to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset. For example, a loan that is secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is secured with collateral.

The financial crisis of 2007 and 2008 was driven by financial institutions investing in subprime home mortgage loans that had a far higher risk of default than bank managers and regulators believed to be possible. When consumers started to default on their mortgages, many financial institutions lost large amounts of capital, and some became insolvent.

To avoid this problem moving forward, regulators now insist that each bank must group its assets together by risk category so that the amount of required capital is matched with the risk level of each asset. The goal is to prevent banks from losing large amounts of capital when a particular asset class declines sharply in value.

Regulators consider several tools to assess the risk of a particular asset category. Since a large percentage of bank assets are loans, regulators consider both the source of loan repayment and the underlying value of the collateral. A loan for a commercial building, for example, generates interest and principal payments based on lease income from tenants. If the building is not fully leased, the property may not generate sufficient income to repay the loan. Since the building serves as collateral for the loan, bank regulators also consider the value of the building itself.

A U.S. Treasury bond, on the other hand, is secured by the ability of the federal government to generate taxes. These securities carry the higher credit rating, and holding these assets requires the bank to carry far less capital than a commercial loan.

Bank managers are also responsible for using assets to generate a reasonable rate of return. In some cases, assets that carry more risk can generate a higher return to the bank, because those assets generate a higher level of interest income to the lender. Managers have to balance the potential rate of return on an asset category with the amount of capital they must maintain for the asset class. If the management creates a diverse portfolio of assets, the institution can generate a reasonable return on the assets and also meet the regulator’s capital requirements.