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Impact of Risk Weighted Asset Calculation on Credit Risk

Risk Weighted Asset Calculation is a significant part of credit risk. In examining the impact of RWA Calculation on Credit risk, it is essential to understand the meaning of both RWA and Credit risk. This will help us understand the relationship between Risk weighted Asset Calculation and Credit Risk.

bank’s assets typically include cash, securities, and loans to individuals, businesses, other banks, and governments. Banks use Assets to trade and make money. Each type of asset has different risk characteristics. Therefore, a risk weight indicate how risky it is for the bank to hold the asset.

Risk-weighted assets (RWA) link the minimum amount of capital required by banks with the risk profile of the bank’s lending activities (and other assets). The greater the risk a bank takes, the more the capital required to protect depositors.

On the other hand, credit risk is the risk of loss due to a borrower’s inability to repay a debt in full or in part. So, banks want to understand the risk value of the assets they hold on to, which is how RWA comes in.

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How is the RWA calculated?

To determine how much capital banks should maintain to guard against unexpected losses, the asset’s value (the exposure) is multiplied by the relevant risk weight.

In simple terms, RWA is calculated by multiplying the exposure amount by the appropriate risk weight for the type of loan or asset. This calculation is repeated for all bank’s loans and assets, and the total RWA is calculated.

It is important to note that two main approaches are used in calculating RWA, and they are:

  1. The standardized approach
  2. The Internal Ratings-Based Approach.

It’s important to note that regardless of the approach adopted, RWA is calculated by multiplying risk weight by the amount of exposure (value of the asset).

The Standardized Approach

This approach is applied using the supervisors’ parameters to calculate the RWA. Here, the bank does not influence the parameters used to calculate the RWA. It’s based on the customer’s external ratings and the exposure type. It is also based on the parameters given by the supervisors to avoid any influence the bank has to overpower how the RWA Calculation is done. This is the standard whether it is a sovereign or bank customer. There are no preferences.

The Internal-Ratings-Based Approach

The Internal-Ratings Based Approach enables banks to model their input for calculating RWA from credit exposures to retail, corporate, financial institutions, and sovereign borrowers. This is subject to supervisory approval.

Typically, only the larger banks have the expertise and infrastructure necessary to use the IRB approach.

It is important to note that the approach used does not matter. This is because the goal is to understand the RWA. Multiplying your risk weight by the amount of exposure (value of the asset) gives the RWA.

The RWA indicates how risky your asset is. As a bank, the higher your RWA, the higher the minimum capital required to protect an asset. Likewise, when the RWA is lower, it indicates your asset’s safety. This information helps banks to make informed decisions in the future.

What Are the Parameters Used for The Different Approaches?

For the Standardized, the parameters used by the bank are based on what the supervisory committee has provided. This means that they look at the external ratings of the customer.

There are diverse types of customers. There are sovereign customers, which include Central government banks. Financial institutions are also customers. There are also corporate customers and retail customers. These customers have different risk characteristics; that is, they have different ratings.

The parameters used also depends on the jurisdiction you are in as well. For example, when the PRA were in the EU, they set preferential treatments for EU countries, such that, if one is a member of the EU, you get professional risk weights which would ultimately reduce your RWA. So the parameters used depend on the type of customer you are and the jurisdiction you are from.

For the Internal Ratings-Based approach, the bank can do their modelling. For example, we have the Probability of Default (PD), which is the internal rating. This is the bank using its measures to provide internal ratings for customers. They could also use the modelled LGD assigned to that exposure. It is pertinent that even though the bank can model their parameters, they still have to take these models for approval.

Benefits of Risk Weighted Asset calculation, other than the determination of CAR

Meanwhile, has earlier been mentioned, calculating your RWA for credit risk can serve as an indication of a risky or safer asset. This would help banks to have a good capital allocation process. This means they can know the type of assets to invest in in the future.

According to the Basel rules, certain products cannot be calculated using the Internal Ratings- Based approach. As mentioned earlier, when banks use the IRB approach, they can model and influence the parameters. However, some products require the standardized approach for the RWA calculation. One of these products is equity. Depending on the type of equity, some exposures are required to be assigned 400% risk weight, whereas some assets are assigned 0%. RWA Calculations help the bank to think about their lending profile. It also encourages financial institutions to review their current financial condition and highlight any red flags in case of minimum capital requirements.

RWA Calculation provides a means for banks to monitor the utilization and protection of depositors’ funds. These assets are customer monies, so RWA calculation helps the bank protect the assets.

The capital Adequacy Ratio is the ratio of regulatory capital to the risk-weighted assets. The capital adequacy ratio (CAR) measures a bank’s available capital as a percentage of a bank’s risk- weighted credit exposures.

Two types of capital are measured in Risk Weighted Asset:

  1. Tier-1 capital, which can absorb losses without a bank being required to cease trading, and
  2. Tier-2 capital, which can absorb losses in the event of a winding-up and provides less protection to depositors.

CAR is a ratio of your tier one capital, which is your tier one capital, and your tier two capital divided by your risk-weighted assets. Tier 1 capital is the primary funding source of the bank and consists of shareholders’ equity and retained earnings. Tier 2 capital includes revaluation reserves, hybrid capital instruments and subordinated term debt, general loan-loss reserves, and undisclosed reserves.

The higher your RWA, the higher the capital you need to set aside as a bank. As a financial institution, the measure of how risky it is to hold an asset on your balance sheet is the definition of your RWA. For example, suppose a bank has too many risky assets on its balance sheet. In that case, this ultimately means they’re lending to customers who cannot pay back. If a bank has too many of them on its balance sheet or is exposed to too many of them, the money coming back into the bank’s buffers needs to be set aside against those assets.

The more risky assets you have on your balance sheet, the more money you need to set aside against those assets. This itself is the business of banking. A bank’s primary source of capital is the deposits of customers. However, RWA ensures that you calculate the risk of lending to your customers.

Importance of Risk Weighted Asset optimization

  1. RWA Optimization enables banks to know the type of asset they have on their balance sheets. If a bank holds too many risky assets on its balance sheet, it won’t be able to collect its money back. However, in theory, the higher the risk, the more you should receive for holding the investment, and the lower the risk, the less you should receive, on average.
  2. Risk Weighted Asset optimization lets banks know the type of customers to do business with. Regulators want banks to optimize their RWA to ensure that banks are prudent. Banks should not lend to customers without conducting the necessary investigations on the customers’ accounts. RWA helps banks look at their customers’ characteristics and lend to them. The

financial crisis of 2007 and 2008 was fuelled by financial institutions investing in subprime home mortgage loans with far higher default rates than bank managers and regulators anticipated. When consumers began to default on their mortgages, many financial institutions lost significant amounts of capital, and some went bankrupt. Some banks had to be bailed out by regulators. Regulators now require that each bank group its assets by risk category so that the amount of capital needed is proportional to the risk level of each asset type.

The goal is to keep banks from losing significant amounts of capital when the value of a specific asset class falls sharply. Therefore, banks need to calculate their RWA for credit risk to avoid bank failure. The impact is remarkably high if a bank fails, most especially if a big bank fails. When this happens, the big bank’s collapse has a ripple effect on other banks, and it will, in turn, affect the economy.

The challenge to Risk Weighted Asset optimization

  • Data quality: To calculate or optimize your RWA effectively, you need the correct information. This means that you need the right information about your customer. The information you put in your risk engine, the system used in calculating your RWA, is the result you get. For example, as a financial institution, if the information you get concerning a customer says that the risk associated with lending to the customer is low, your RWA will be low. Likewise, suppose information obtained shows that the risk associated with lending to a customer is high. In that case, RWA will be increased. The information you see is what you get. To effectively optimize your RWA, you need quality data. For many banks, this problem starts from the information collected while onboarding the customer. The information gathered significantly impacts the downstream consumption of such data over time. It affects your RWA calculation as you move toward the credit risk management process.
  • Lack of investment in Technology: It’s very evident that some banks still use Excel in calculating their Risk Weighted Asset for credit risk. This has caused issues as using Excel makes it slow and difficult to optimize, making your RWA calculation useless. It is imperative to invest in modern technology to calculate your RWA. Banks that invest in technology are allowed to use the internal rating-based approach. Hence, there is a need for a sophisticated application as a risk engine to calculate your RWA effectively.

Other challenges includes;

  • Inadequate Training: Banks need to invest in their resources. A bank’s staff need knowledge of credit risk and RWA calculation to capture the correct information adequately. Knowledge is vital, and banks need to train their staff to understand the exposure.
  • Faulty implementation of regulatory policies and requirements, e.g., Basel Regulations: The regulatory policies keep changing, making it necessary for banks to keep themselves abreast of the recent changes. There are different implementations in different jurisdictions when it comes to capturing the requirements of the Basel committee. Only the so-called members of the Basel committee thoroughly implement the Basel 2, Basel 3, and Basel 4 requirements. However, other jurisdictions or countries should ensure they implement the Basel regulation accordingly or based on the committee requirements as there are so many loopholes. Bank regulators also need to ensure that they implement the correct requirements. If the regulation is incorrect, then the banks’ implementation would be wrong.

There are many challenges to optimizing RWA; however, these are the critical challenges to RWA optimization.

Has technology allowed financial institutions to access data and explore giving out loans to customers?

The answer is YES. Technology is the driving force of banks’ lending as so many FinTech companies are springing up. The world is gradually moving from the traditional style of banking to a technologically advanced one, making it easier for people to make transactions online. Nowadays, you do not need to go to a bank to open an account or apply for a loan. You can do all of that online now. However, as good as this may seem, it is also precarious.

Banks must be careful and ask questions like, “Do I know my customer? Will this customer be able to pay back eventually? Banks need not lose their focus and ensure things are done in order by conducting the due diligence of knowing their customers and knowing the ability of the customer to pay back. For every customer, banks need to calculate the RWA, which is the risk associated with lending to that customer either before or after lending to them.

Did COVID-19 affect the approach used in calculating RWA?

The answer is NO. COVID 19 has nothing to do with the approach that you use for your RWA calculation. The necessary thing needed is to get approval from your regulator. No regulation around COVID-19 gives the method you use for your risk-weighted asset calculation. Everything depends on getting permission from the regulators. It depends on the internal workings of the business analyst, the product owners, or the approach that all the stakeholders want to adopt. It is their discretion to choose the method they feel is best for their RWA calculation.

Get a free RWA calculation tool

BST consulting Limited is a firm of seasoned risk consultants specialized in Credit Risk, Liquidity Risk, Market Risk and Operational Risk, under the Basel regulations. The company has automated the calculation of Risk Weighted Asset. You can calculate RWA on the fly here.

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