Anna Michael - Risk Weighted Assets: Basel III (Banking Simplified Book 1)

Risk weighted assets is the foundation for assessing the risk of unexpected losses of deposit taking financial institutions. As that sentence may have been hard to understand read it again after finishing the book.

This book provides a simple explanation for Risk Weighted Assets for novice bankers as well as bankers who are moving into the Risk domain of a financial institution. It is also relevant for any business having exposure to risk, especially credit risk.

Risk-weighted assets are arrived at from different risk perspectives. These are credit risk, interest rate risk, market risk and operational risk. The methodology used is primarily credit risk driven. The methodology is then extended to arrive at a similar dollar value for interest rate, market and operational risk.

Credit risk can lead to expected loss and unexpected loss. Expected loss is covered by loan-loss provisions and unexpected loss by equity arrived at by risk-weighting assets. Considering risk-weighted assets look at residual risk it is important to understand loan loss provisioning before we get into risk-weighted assets. In case you already understand loan-loss provisioning you can go straight to the chapter on credit risk weighted assets.

To understand expected risk and provisioning for expected losses we will go into the inputs required for Loan Loss Provision, namely Customer Credit Rating , Exposure Amount and Collateral Quality . We will also briefly discuss the changes introduced in IFRS 9.

Once an understanding of expected loss is gained we will look at the risk of unexpected losses inherent in Credit assets and the assessment using the Risk Weighted Assets method as prescribed by Basel III.

Following this we will expand Credit RWA to Interest Rate, Market and Operational Risk.

The key topics covered are as follows:

1. Expected Loss and Loan Loss Provisions
2. Credit Risk & CRWA
3. Standardized and Advanced Approaches
4. Interest Rate Risk & IRRWA
5. Market Risk & MRWA
6. Operational Risk & ORWA
7. Summary

Credit Risk is the risk of not receiving an amount due to us because of a counterpartys lack of willingness or ability to pay the same. For example, if a loan is given to a corporate, how do you quantify the risk of not getting the principal and interest due to the bank. We say we have an exposure to Credit Risk. Just as exposure to the sun leads us to a risk of cancer, lending leaves us exposed to credit risk the risk of not getting our money back.

As a banks main business is lending, credit risk primarily includes risk of non-payment of principal and interest.

Credit Risk is quantified by calculating the average of losses seen historically on a loan with similar characteristics. This average is the Expected Loss and is calculated on an exposure over a specific period of time. In this chapter we will consider the Expected Loss over a 1-year horizon unless stated otherwise.