Now that we’ve covered capital in some detail, let’s move to the second most important technical parameter used in banking regulations. We’re talking about risk-weighted assets (or RWA). If you’ve seen bank financial statements, then you might have noticed the “RWA” term there.
Bank assets and risks
A bank’s primary business is to make money from its assets. The assets are primarily in the form of loans. Some banks may also hold various securities as investments—especially for investment banks. But not all loans or investments have the same sort of risk.
Loans that are given by a bank such as JPMorgan (JPM) or Wells Fargo (WFC) to a company that has an AAA bond rating, such as Microsoft or Johnson & Johnson, will have a lower risk because the chance of default will be lower.
But a mortgage loan given by a bank like Citigroup (C) to a subprime lender will carry a much larger risk. Similarly, an investment in government bonds by an investment bank like Morgan Stanley (MS) will carry a much lower risk than an investment in a BB-rated bond company.
Calculating risk-weighted assets
In calculating risk-weighted assets, we first segregate a bank’s loans and investments into separate categories. Each category has a risk weight. For less risky loans and investments, this risk-weighted value is low. For more risky assets and investments, this risk-weighted value is high.
The amount of loans or investments in each category is then multiplied by its corresponding risk-weights to get the bank’s risk-weighted assets. All banks in an ETF like the Financial Select Sector SPDR Fund (XLF) calculate risk-weighted assets similarly.
Now that we’ve covered both capital and risk-weighted assets, we’ll move to a ratio that brings together both these parameters to create one of the most commonly used ratios in banking regulations.