CRAR - Risk-Weighted Assets

The regulatory capital requirements evolved as innovation in the financial instruments and banking activities, where a lot of complexity is involved.

The regulatory requirements should keep up with the changing global preference and business criteria.

Hence, the federal banking agencies have been introducing revised rules for qualifying capital instruments and the minimum capital levels.

The risk weighing system was introduced in the US in the 1990s, while the general-purpose risk weighing has not changed.  

The set of requirements as compared to the risk factor of the asset is compared by the regulatory capital, where the bank calculates the risk-weighted assets to decide if they should fund an asset or not, as compared to the risk.

The risk-weighted asset number is used for calculating the capital ratio. 

In a bank’s balance sheet, assets, and credit, the equivalent is mostly assigned in 4 categories (0, 20, 50 and 100 per cent) according to the obligor, the guarantor or the nature of the collateral. 

FB (On-Balance sheet) items: Assets such as cash, loans, investments, and others, to which the degree of risk expressed as %age weights have been assigned by the central bank under the Standardized approach.

NFB (Off-Balance Sheet) items: (LC, BG, etc.) First, multiplied by the credit conversion factor. This will be again multiplied by the relevant risk weightage to calculate the risk value.

HVCRE loans – The loans referred to as a subset of acquisition, development, and construction are assigned 150% on risk weighting. It does not include 1-4 family residential ADC projects or loans to agricultural properties. 

ICAAP: It comprises a bank’s procedure and measures to ensure:
Identification and measurement of risks;

An appropriate level of internal capital for the bank’s risk profile; and

Application and further development of suitable risk management systems in the bank. 

Credit risk is defined as the possibility of losses associated with default by or diminution in the credit quality of Borrowers or Counterparties arising from: 

Outright default due to the inability or unwillingness of a borrower or counterparty to meet commitments about the lending, trading, settlement, and other financial transactions; or 

Reduction in portfolio value arising from actual or perceived deterioration in the credit quality of borrowers or counterparties.

Default: -Default is considered to have occurred when an asset is classified as NPA in its prudential norms on Income Recognition, Asset Classification Provisioning about advances.

Probability of Default (PD): Probability that the borrower will default within a one-year horizon. 

Exposure at Default (EAD): Gross exposure/potential gross exposure under a facility (i.e. the amount that is legally owed to the bank) at the time of default by a borrower.

Loss Given Default (LGD): Bank’s economic loss upon the default of a debtor/borrower.

Effective Maturity (EM): Effective maturity of the underlying should be gauged as the longest possible remaining time before the borrower is scheduled to fulfil its obligations. 

Expected Loss (EL): Part of the average anticipated credit loss happens in the normal course of business due to default in exposures. These losses are viewed as a cost component of doing business and are managed by pricing, provisioning, etc.

Unexpected Loss (UL): There are instances when losses exceed the average expected loss levels. This amount of loss over and above the expected losses is referred to as unexpected loss and is the standard deviation (at a specific confidence level) from the expected losses. These losses are covered by keeping capital as a cushion. 

Market Discipline

Banks should provide qualitative and quantitative disclosures related to the liquidity risk or credit risk vs liquidity risk.

It effectively informs the market about a bank’s exposure to financial risk and provides a consistent and comprehensive disclosure framework that enhances comparability.