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

Why do we apply risk weights when analyzing capital adequacy? Why don’t we simply add all assets?

Risk weights assets calculation is useful for capital adequacy ratio i.e finding the minimum capital a bank should maintain in order to avoid insolvency. Now in a bank's asset book or Loan book, there are various types of assets like a mortgage loan or an unsecured business loan. Comparing these two type of assets  unsecured business loan is much riskier than mortgage loan. So we can not keep on adding both as both carry a different level of riskiness. To add both assets we have to multiply by risk weights to the total asset value in each category.

Discuss. Also, discuss what banks are likely to do if risk weights were abolished.

Now if risk weights were abolished both mortgage loans and an unsecured business loan will be on par. But an unsecured business loan will generate more interest income to the bank. So the bank will lend more and more in riskier assets to gain more profit. But the risk of the bank's portfolio will increase enormously as they will not maintain capital as per the risk weights of the assets and shortly create a liquidity crunch. If more and more unsecured loans start to default.