When a bank fails it sends shock waves rippling through the economy. Risk-weighted assets are one of the tools used to prevent the shock waves. Banks have to keep a minimum amount of capital on hand to cover the risk of borrowers defaulting or investments flatlining. The bank evaluates the bank's assets, "weigh" different types according to the risk, then calculate how much capital will balance the risk.
Bank assets are more than the cash in the vault. Loans and investments are assets, but they're not as safe as cash. Every loan a bank makes comes with a risk the borrower might default. Most investments come with the risk of losing the investment. Different bank assets have different degrees of risk: investing in T-bills is very low risk, while high yield junk bonds are much less secure. Loaning money to Microsoft is safer than loaning to a struggling start-up. A loan secured by real estate offers a lower risk than one with no collateral.
To calculate risk, the bank segregates the different assets into different groups, based on the level of risk and the potential for loss. The bank then applies the same risk-weighting formula to all the assets in each group.
The rules for risk weighting are set by global banking overseers based in Basel, Switzerland. As of 2018, the risk-weighting rules are set by a worldwide financial agreement known as Basel III, though some risk-weighting is still covered by the earlier Basel II. Basel III is significantly tougher.
Under the Basel rules, banks must hold capital equal to 7 percent of their risk-weighted assets. If the risk-weighted assets equal $500 million, the bank needs $35 million in capital. That amount should cover the bank's exposure if any of the potential losses become reality.
Some investments, such as AA-rated government bonds, come with a zero risk. The bank doesn't have to worry about potential loans. Corporate loans above AA-rated are weighted at 20 percent. The Basel rules consider credit risk the top priority in identifying risk class. Next comes operational risk. This covers risks such as internal fraud, negligence or error. Market risk is a third, much less significant element.
Risk-weighting is supposed to provide an unbiased formula for assessing whether a bank is overextended. In practice, two banks with almost identical asset classes can come up with a completely different risk weight. One bank's number-crunchers look at the assets and claim a much lower risk of default than the other bank. That justifies a lower risk-weighting, which reduces the amount of capital the bank has to have. That's one of several ways banks can tinker with the calculations to lower their capital requirements.