Risk weighted assets
Sector Deep DivesA bank's assets scaled by their riskiness, forming the denominator of regulatory capital ratios.
Also written: RWA
Not every asset carries the same risk, so regulation weights them: government bonds may attract a zero or very low weight, prime mortgages a low one, unsecured corporate lending a full one or more.
Capital ratios are expressed against this base. A common equity tier 1 ratio is CET1 capital divided by risk weighted assets, and the minimum a bank must hold is set against that denominator.
It makes capital the binding constraint on a bank's growth. Writing more loans consumes capital, so a bank near its minimum cannot grow the balance sheet without raising equity, retaining earnings or shifting mix toward lower weighted assets.
It is also why returns are measured on capital rather than assets. Return on tangible equity against the cost of equity is what determines whether a bank trades above or below tangible book value.
Worked example
A bank holds 10,000 of government bonds at a 0% weight, 20,000 of prime mortgages at 35%, and 15,000 of unsecured corporate loans at 100%.
Risk weighted assets are 0 plus 7,000 plus 15,000, so 22,000, against 45,000 of actual assets.
With 2,640 of CET1 capital the ratio is 12%. Writing 1,000 more corporate loans adds 1,000 of RWA and drops the ratio to 11.5%, which is how capital rather than funding becomes the binding constraint on growth.