Risk-Weighted Capital Overview

With the advent of deregulation and increased competition, financial managers are recognizing the limitations of the traditional focus on asset growth, market share, or interest earnings per share, all of which ignore inherent business risks and can be misleading performance indicators. The emphasis is shifting to risk-adjusted return on capital (RAROC), which recognizes the importance of capital adequacy. Too little capital can lead to a liquidity crisis (in the event of unexpected losses), and too much capital lowers the return on shareholders' equity.

The role of capital is to act as a buffer against unexpected losses and to minimize the likelihood of an institution's failure. Institutions typically create provisions against identified losses (loss reserves); and they allocate capital to absorb any unidentified losses. Risk-Weighted Capital (RWC) enables you to systematically assess your risk exposure and to calculate your capital allocation needs and normalized loss (loss reserve) needs. Normalized loss distributes your expected losses across periods, and it levels the income/loss streams.

You can perform your risk analysis for ledger accounts, products, instrument pools, or treasury positions. You can assign risk weights corresponding to different risk types that you define for your organization; or you can define functions that the system uses to calculate the risk weights.

In some cases, the institution may choose to allocate excess capital (for example, to support superior credit ratings or to satisfy depositors' requirements). Risk-Weighted Capital allows you to define a set of formulas for your risk weights corresponding to your targeted capital requirements. You can use Risk-Weighted Capital to measure book capital against your risk-weighted capital, so that you can determine whether your organization is over or under capitalized.