Risk-weighted assets are used by the US Federal Reserve Board to determine the amount of capital a bank must have available to avoid financial failure. Each asset is assigned a risk weight based on the amount of risk involved. The amount of capital a bank must have on hand to cover this risk is determined by the total of risk-weighted assets.
Risk-weighted assets are those held by a bank or other financial properties that are weighted according to their level of risk. The US Federal Reserve Board uses this asset risk assessment system to determine the amount of capital a bank must have available at any time to avoid financial failure. A bank must contain capital that measures at 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 departure from static requirements. It stands to reason that a bank that is well stocked with cash is more financially sound than one that relies heavily on loans and credit. This system helps prevent a bank from taking on more risk than it can cover in the event that some of its less stable businesses fail.
In a risk-weighted asset system, certain assets are assigned a risk weight that is multiplied by the actual value of the asset available. Letters of credit or debentures and ordinary loans have a risk weight of 1.0, while mortgage loans are at 0.5 and interbank loans are at 0.2. Cash and government securities are not risk-weighted because there is no risk associated with these assets.
For example, Bank A has letters of credit for $2,000 USD, ordinary loans outstanding for $500 USD, mortgage loans for $600 USD, and interbank loans for $1,000 USD. Using the risk weights according to these values, $2,000 is multiplied by 1.0 to get $2,000. 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 US 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 need to have Tier 1 capital equal to $120 USD and total capital of $240 to offset its risks.
Smart Asset.
Protect your devices with Threat Protection by NordVPN
