In Step 5, how have we decided the weights to be as 0%, 100% & 150%? Is there any logic behind this or does it depends upon the discretion of banks?
In Step 6, why do bank consider them to be Off B/S & not on B/S?
Please help in understanding this. Thank you!
1)
The capital adequacy ratio (CAR) is a measure of a bank’s financial strength, which compares the bank’s capital to its risk-weighted assets. The risk weights are used to determine how much capital a bank must hold to cover potential losses on its assets.
The risk weights are determined based on the perceived risk of each asset or category of assets held by the bank. The riskier an asset is, the higher the risk weight assigned to it, and therefore the more capital the bank must hold against it. For example, loans to customers with poor credit history are considered riskier and will have a higher risk weight than loans to customers with good credit history.
The determination of risk weights is based on the guidelines provided by the Basel Committee on Banking Supervision. These guidelines classify assets into several categories, such as sovereign bonds, corporate bonds, residential mortgages, commercial mortgages, and consumer loans. Each category has its own risk weight, which reflects the level of risk associated with the assets in that category.
In addition to the guidelines provided by the Basel Committee, banks are also required to consider their own internal assessment of the risk associated with each asset or category of assets. Banks may use internal rating systems to assess the risk of their assets and determine appropriate risk weights.
Once the risk weights are determined, the bank calculates its risk-weighted assets (RWA) by multiplying the amount of each asset by its assigned risk weight. The capital requirement is then calculated by multiplying the RWA by the minimum capital requirement ratio specified by the regulator. The resulting amount represents the minimum amount of capital that the bank must hold to cover potential losses on its assets.
2)
On-balance sheet risk-weighted assets (RWAs) are those assets that are recorded on a bank’s balance sheet and are subject to capital requirements. These are typically loans and securities that are held by the bank and are included in the calculation of the bank’s capital adequacy ratio (CAR).
Off-balance sheet RWAs, on the other hand, are not recorded on the bank’s balance sheet but still represent potential risks to the bank. These are typically contingent liabilities, such as guarantees, letters of credit, and derivatives, that the bank has issued to its customers. These obligations are not recorded as assets or liabilities on the balance sheet but are still considered to be potential claims against the bank’s assets.
The calculation of off-balance sheet RWAs is more complex than that of on-balance sheet RWAs because they involve estimates of potential future losses. The amount of capital required to cover these potential losses is determined by applying risk weights to the off-balance sheet items based on their perceived level of risk.