Since the 1980s, the international community has taken steps to ensure that banks hold adequate levels of capital commensurate with the risk of their operations. Under the auspices of the Bank for International Settlements, a regulatory framework called "Basel II" has emerged. It calls for the calculation of risk-weighted assets to determine how much capital each financial institution must hold.
Select your approach to credit risk. Under Basel II, financial institutions can choose from three approaches: standardized, internal ratings based (IRB) and advanced IRB. The standardized approach determines an institution's risk profile based on a combination of predetermined asset risk weights and external ratings. Unless your institution has a sophisticated internal risk management system in place, choose the standardized approach.
Identify and categorize all assets on the balance sheet. Refer to the Basel II categorization of assets and corresponding risk weights. For example, loans secured by residential property carry a risk weight of 35 percent as long as the loan-to-value ratio is less than 80 percent. Predetermined risk weights should be used for all assets except for loans to sovereigns, corporates and banks, where lenders should refer to external credit ratings.
Compute the risk-based capital requirement. Match your institution's assets with the appropriate risk weights to determine the risk-based capital that you must hold. For example, if your institution made a $200,000 mortgage loan to a buyer of a single-family home worth $300,000, you must hold $70,000 of capital, equivalent to 35 percent of $200,000.
Estimate additional capital for operational risk. Besides credit risk, you must assess the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. One example of a non-credit risk that you must consider is interest rate risk. If interest rates rise, for example, your institution may have to write down the value of some of its fixed income assets.
The global financial crisis that began late in the first decade of the 2000s revealed the weakness of Basel II's approach to risk management. Be vigilant of risk and carefully consider taking measures above and beyond those recommended by regulators.
- Comstock/Comstock/Getty Images