Risk Weighted Assets, Capital Adequacy Ratio

 

Risk Weighted Assets (RWA) ----

• Assets of Banks which are weighted according to the risk.
• RWA are useful in calculating the minimum amount of capital required in compliance to the existing regulations to avoid insolvency and protecting its depositors and investors.
• RWA is used in calculating Capital adequacy Ratio (CAR).
• Riskier the asset --Greater amount of Regulatory capital is required.
• So, G-Sec has least amount of risk while loans to corporates have higher amount of risk, and other instruments lying in between. 

To Understand:

Rs.1bn in G-sec, 

Rs.2bn secured by mortgages, and 

Rs.3bn of loans to businesses. 

The Risk Weight according to Assets are:

1. 0% for G-Sec 
2. 50% for mortgages, and 
3. 100% for the corporate loans. 

The bank's risk weighted assets are:

0 × Rs.1bn + 50% × Rs.2bn + 100% × Rs.3bn = Rs. 4bn. 

So, out of total Rs 6 bn, RWA of the bank is Rs 4 bn. 

Capital Adequacy Ratio (CAR):

The CAR is the capital needed for a bank to meet any financial risk.

CAR is measured in terms of assets (mostly loans) disbursed by the banks. 

The higher the assets, the higher should be the capital retained by the bank and Mathematically:

CAR:

Tier 1 + Tier 2 capital / RWA.

To Understand:

If Banks Tier 1 capital =Rs 12bn and Tier 2 capital = Rs 20 bn. 

Then CAR =

Tier 1 Capital + Tier 2 Capital​ / Risk Weighted Assets =

32/RWA

Since CAR represents a number that shows the risk cushioning health of the bank, banks are required to maintain a safe, higher number to signify their favorability.