03. Risk-Weighted Assets: Four different risks, four different categories
Not all assets carry equal risk. A government bond and a subprime mortgage cannot demand the same capital.
#BankingRegulation #BaselIII #RWA #CreditRisk #FRTB #RiskManagement #BankingMetricsSeries
Banks hold capital against unexpected losses. RWA is how they size it — source by source.
Every euro on the balance sheet asset gets a risk weight: RWA = Σ (Asset × Risk Weight).
The weight is where the work is. A short-term sovereign bond and a subprime loan cannot demand the same number.
Four categories cover the main sources of loss.
Credit Risk — the mortgage client stops paying, the corporate borrower defaults. Banks either apply fixed regulatory weights or estimate their own parameters, depending on portfolio and supervisor permission. That second route is the heart of credit risk modeling.
Market Risk — the trading book moves against the bank. Rates, spreads, FX, equity prices, all hitting bank Profit&Loss. FRTB replaced the old VaR regime with Expected Shortfall at 97.5%, a measure that finally captures tail losses.
Operational Risk — fraud, IT outages, litigation. Losses with no direct link to a market or a borrower. A single Standardised Approach now sizes the requirement, anchored on a Business Indicator (scaled income) and the bank's own loss history.
CVA Risk — an OTC derivative counterparty becomes less creditworthy. The counterparty isn't in default, but the mark-to-market value of the exposure still drops. SA-CVA mirrors FRTB's sensitivity logic, and there is no possibility for an internal model approach.
Sitting above all four: the Output Floor at 72.5%. It caps how much capital banks can save through internal models — the biggest change in capital regulation since 2010.
Swipe through for each category 👇
