Question

Why do we apply risk weights when analysing capital adequacy? Why don’t we simply add all assets? Discuss. Also, Discuss what banks are likely to do if risk weights were abolished.

Answer 1

Capital adequacy is maintained as a cushion and is determined by how risky the assets are of a bank.

Risk weights are applied because all the risky assets of a bank are not equally risky. An asset X might br only half as risky as an asset Y. Hence, to correctly assess the impact of risky assets, risk-weighted assets is taken while considering the capital adequecy ratio.

Had the risk weight been abolished, banks are equally likely to take up a more risky asset on its balance sheet as a less risky asset. This is because both would result in the same capital adequecy ratio, even though the actual riskiness of the assets is different.