In our series ‘Bank jargon made relevant’, we explain frequently used words, acronyms and concepts that feature in banking discussions. An awareness of these concepts will help remove some of the intended confusion and assist in your next bank negotiation.
Risk-weighted assets are the key link between your businesses lending limits and the amount of capital a bank must hold in reserve against it.
As the name implies, it is calculated as:
RWA = Risk weight x Assets
Risk weight is the percentage. Assets related to Lending Limits. For example;
RWA = 20% x $20.0m
RWA = $4.0m
There are several categories of risk weighted assets that determine a bank’s capital requirements.
- Credit risk-weighted assets
- Operational risk-weighted assets
- Market risk-weighted assets
- Interest rate risk in the banking book risk-weighted assets
An increase in risk-weighted assets results in an increase in capital requirement.
Similarly, at a ‘per lending product for a firm’ a decrease in risk weight reduces the risk-weighted assets resulting in a lower capital requirement.
Impact on margin pricing
It is highly likely your banker has used increasing capital requirements to justify a margin increase sometime over the past 10 years.
But what they may not have told you is that credit risk-weighted assets are by far the largest contributor towards a banks risk-weighted asset base. Total risk-weighted assets multiplied by APRAs capital requirement determines the capital base. A bank must earn appropriate returns on this capital base which is via fees and margins.
Credit risk-weighted assets are determined by both financial performance (firm’s riskiness) and security (firm’s collateral). Over the past 10 years whilst regulatory changes have increased capital requirements for banks, your individual firm’s financial performance and valuation of collateral may have more than offset those increases.