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Risk Weighted Assets (RWA): Meaning

What is Risk Weighted Asset(RWA)?
The notional amount of the asset is multiplied by the risk weight assigned to the asset to arrive at the risk weighted asset number.

Risk weight for different assets vary e.g. 0% on a Government Dated Security and 20% on a AAA rated foreign bank etc.

What is Capital to Risk Weighted Assets Ratio(CRAR)?

Capital to risk weighted assets ratio is arrived at by dividing the capital of the bank with aggregated risk weighted assets for credit risk, market risk and operational risk. The higher the CRAR of a bank the better capitalized it is.

In India, Banks are required to maintain a minimum capital to risk weighted assets ratio of 9%. Non-bank subsidiaries are required to maintain the capital adequacy ratio prescribed by their respective regulators. In case of any shortfall in the capital adequacy ratio of any of the subsidiaries, the parent should maintain capital in addition to its own regulatory requirements to cover the shortfall.

Credit Risk

The risk that a party to a contractual agreement or transaction will be unable to meet its obligations or will default on commitments. Credit risk can be associated with almost any financial transaction. BASEL-II provides two options for measurement of capital charge for credit risk.

1. Standardised Approach (SA) - Under the SA, the banks use a risk-weighting schedule for measuring the credit risk of its assets by assigning risk weights based on the rating assigned by the external credit rating agencies.

2. Internal rating based approach (IRB) - The IRB approach, on the other hand, allows banks to use their own internal ratings of counterparties and exposures, which permit a finer differentiation of risk for various exposures and hence delivers capital requirements that are better aligned to the degree of risks. The IRB approaches are of two types:

a) Foundation IRB (FIRB):The bank estimates the Probability of Default (PD) associated with each borrower, and the supervisor supplies other inputs such as Loss Given Default (LGD) and Exposure At Default (EAD).

b) Advanced IRB (AIRB):In addition to Probability of Default (PD), the bank estimates other inputs such as EAD and LGD. The requirements for this approach are more exacting. The adoption of advanced approaches would require the banks to meet minimum requirements relating to internal ratings at the outset and on an ongoing basis such as those relating to the design of the rating system, operations, controls, corporate governance, and estimation and validation of credit risk components, viz., PD for both FIRB and AIRB and LGD and EAD for AIRB. The banks should have, at the minimum, PD data for five years and LGD and EAD data for seven years. In India, banks have been advised to compute capital requirements for credit risk adopting the SA.

Market risk

Market risk is defined as the risk of loss arising from movements in market prices or rates away from the rates or prices set out in a transaction or agreement. The capital charge for market risk was introduced by the BASEL Committee on Banking Supervision through the Market Risk Amendment of January 1996 to the capital accord of 1988 (BASEL I Framework). There are two methodologies available to estimate the capital requirement to cover market risks:

1) The Standardised Measurement Method: This method, currently implemented by the Reserve Bank, adopts a 'building block' approach for interest-rate related and equity instruments which differentiate capital requirements for 'specific risk' from those of 'general market risk'. The 'specific risk charge' is designed to protect against an adverse movement in the price of an individual security due to factors related to the individual issuer. The 'general market risk charge' is designed to protect against the interest rate risk in the portfolio.

2) The Internal Models Approach (IMA): This method enables banks to use their proprietary in-house method which must meet the qualitative and quantitative criteria set out by the BCBS and is subject to the explicit approval of the supervisory authority.

Operational Risk

The revised BASEL II framework offers the following three approaches for estimating capital charges for operational risk:

1) The Basic Indicator Approach (BIA): This approach sets a charge for operational risk as a fixed percentage ("alpha factor") of a single indicator, which serves as a proxy for the bank's risk exposure.

2) The Standardised Approach (SA): This approach requires that the institution separate its operations into eight standard business lines, and the capital charge for each business line is calculated by multiplying gross income of that business line by a factor (denoted beta) assigned to that business line.

3) Advanced Measurement Approach (AMA): Under this approach, the regulatory capital requirement will equal the risk measure generated by the banks' internal operational risk measurement system. In India, the banks have been advised to adopt the BIA to estimate the capital charge for operational risk and 15% of average gross income of last three years is taken for calculating capital charge for operational risk.

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