RISK-WEIGHTED ASSETS (RWA) (ENCYCLOPEDIA)
Risk-weighted assets (RWA) represents an aggregated measure of different risk factors affecting the evaluation of financial products. All the risk components are considered together to “correct” the nominal value of financial assets. In this way, a proper measure of the extent to which the underlying risk is increasing or decreasing the accounting value of financial assets is generated. This assessment attributes a high weight-coefficient to high-risk financial assets, and a low-weight coefficient to low-risk ones. For example, let’s consider two financial assets with the same nominal value:
- a corporate bond with a medium/long-term duration of a company presenting negative losses during the last three years, and a BBB rating;
- a sovereign bond with a short-term duration of a country presenting a low systemic risk, and a AAA rating.
Hence, the first financial asset will produce higher RWA compared to the second one.
As the Basel Committee points out, RWA play a very important role in the banking sector, helping banks monitoring their efforts in achieving capital adequacy goals (see Basel I1, Basel II2, Basel III3). RWA quantification affects the amount of capital the bank will have to retain to be compliant with the imposed capital adequacy requirements. This amount, which cannot be invested in risky projects, will be indeed a non-interest bearing money-sum. In light of this, banks have arranged internally RWA monitoring and reduction strategies to contain risk, e.g., to minimize expenses on otherwise greater capital provisions. These strategies, which mainly focus on the improvement of asset quality, imply the choice of those counterparties showing the lowest risk profile for a given level of return on investments.
Major risk components of the RWA calculation are Credit risk, Market risk, and Operational risk.4 Assets, weighted by these components and taken altogether, represent the RWA.
Assuming a lender and a borrower, Credit risk can be seen as the borrower-default risk (counterparty risk), taking place when the he is no longer solvent, i.e., when he is not able to return money back. This risk could relate to the interest rate-quota of the loan, to the capital-quota, or both. Credit risk generates from every financial transaction and weighs on the lender, whatever the technical form of the loan is (e.g., a mortgage loan granted to buy a house, a credit card, a personal loan, or a credit line provided to a company to finance its productive activity).
Other two risks can be included into the broader category of credit risk. The first refers to the risk that the borrower delays his payments related to both interest and capital quotas (i.e., Past-due credit risk). The second, refers to the so called Country risk, applying when the borrower operates in a country with a high systemic risk. In this case, the lender may suffer from foreign currency problems.
Generally, the lender implements actions to reduce credit risk. For example, he may want to incorporate the risk directly into the transaction price (risk-based pricing) which consequently increases to account for borrower’s probability of default. Similarly, he can also ask for transaction collaterals, or he can eventually buy an insurance policy to protect himself from the credit risk (credit default derivatives). Despite all these possibilities, if the lender evaluates that he is not sufficiently covered against credit risk, then negative effects on lending activity could arise, such as credit crunch effects, resulting in either the provision of a smaller amount of money to the borrower vis-à-vis the required amount, or the request for a higher collateral.
Market risk is represented by the probability that the value of a financial asset, traded on a sufficiently liquid marked, changes due to not predictable market factors. These factors can be linked to the uncertainty connected to some financial indicators such as the interest rates (e.g. Euribor and Libor), the spread between risky and risk-free government bonds, exchange rates, and real indicators like inflation or unemployment rates. Typically, risk market evaluation aims to quantify the unexpected loss for a financial asset, by using ad hoc models (e.g., Value at Risk models). These models quantify the maximum potential loss, to which a confidence interval applies, that can be generated by the above-mentioned market factors during a specific time horizon.
The Basel Committee defines Operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events”.5 In other words, it represents the probability that the value of a financial asset is influenced by unpredictable factors, resulting from running the bank activity. Bank employees can incur into calculation errors, or into procedural blocks that could temporarily prevent the correct execution of financial transactions (business disruption & systems failures, execution, delivery & process management mistakes). On the other hand, they can face internal and external fraud problems or robberies causing a loss in financial resources. Other risks belonging to this category involve all legal issues (clients, products, & business practice), as well as the loss of physical goods underlying any transaction (damage to physical assets).
Like market risk, a proper evaluation of operational risk is provided by advanced statistical models. Among others, the AMA - Advanced Measurement Approaches6 - is perhaps the most diffused model type and bases on the modelling of all the events from which operational risks derive. This is done by first collecting frequency data and by considering variables with a predictive power in terms of future incident occurrence. The final aim is that of evaluating the size of operational risks to be included into the RWA calculation, and mitigate therefore the risk as much as possible.
4However, in the RWA regulation also other minor risk components are contemplated: in particular, also RWA generated by securitization exposure risks have to be considered, and other less relevant types of RWA. For a more complete detail of different risk types to consider into the RWA calculation, see Basel III official regulation and FAQs. http://www.bis.org/bcbs/qis/qiscompfaq.pdf
Editor: Melania MICHETTI