Role Of Risk Adjusted Assets In Bank's Capital
Assets are intended to earn returns and in the same line banks' assets are also
assumed to gain profits, however they are not free from various risks. Credit risk, market risk and operational risks loom over these assets and the risk proportion varies. Hence, to identify the precise amount of assets which are exposed to these risks, banks are required to calculate risk adjusted assets (RAA).
Normally, banks' assets are in the form of cash, investments in government securities, bonds, debentures, loans to corporates / individuals etc. As government securities are backed by government guarantee, the credit risk is assumed to be less compared to debentures, loans to corporates. Thus, risk component varies among asset categories and such risk percentages are derived by approaches viz., standardized approach, internal rating based approach developed by Basel Accord. The standardized approach specifies standard risk weights for various asset categories which are usually implemented by most national regulators. Cash and short term government securities are considered risk free and a 0% risk is assigned while exposure to OECD banks is assumed to have a 20% credit risk, mortgage loans 50% and unsecured commercial loans at 100%. Lately Basel also advised banks to have 150% risk weight for loans to borrowers with low credit ratings.
Banks usually aggregate assets of one category and assign a risk percentage to the category. The aggregate amount is then multiplied with the risk percentage to arrive at the risk adjusted amount for the specific asset category. For ex: the aggregate investment in mortgage loans of a bank stands at $ 20 mn and the risk percentage is arrived at 50%. Risk adjusted mortgage loans are (20mn * 50%) = $ 10 mn. Non fund assets which are usually off-balance sheet items are also required to be considered to arrive at total RAA of the bank.
Risk adjusted assets are calculated principally to arrive at the capital requirement of banks as required by Basel Accord. Banks are required to maintain at least 8% of their risk adjusted assets as their total capital out of which a minimum of 4% is to be held in Tier I capital as per Basel II regulations. Tier I capital is considered the core of bank's financial status and it usually comprises of share capital and retained earnings. Tier II capital also a measure of bank's financial position consists of special reserves, provisions, subordinated debt, hybrid instruments.
Risk adjusted asset calculation not only helps banks to maintain adequate capital but also tweak their portfolio to lesser riskier assets.
by: kellyprice1225
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