What is RWA? what is the difference between RWA and risk capital?

[FxReX80]

In the textbook of operational risk, RWA is mentioned frequently while talking about BASEL ACCORD. Another concept is risk capital that is a sort of cushion for various risks. What is RWA? what is the difference between RWA and risk capital?

 

[David Harper CFA FRM]

Hi @FxReX80 These are each big concepts (eg, entire chapter on risk capital in FRM P2.T7). I would just offer one high-level perspective, if you think about a bank's balance sheet: assets (on the left-hand side) equal liabilities plus equity (on the right-hand side). Or, equity = assets minus liabilities. The assets can be book (accounting) or market value. But risk-weighted assets (RWA) adjusts the assets by weighting them; e.g., 0% if no risk, 100% if full risk. Given the same book/market assets, RWA will be higher for riskier assets such that Basel will require more regulatory capital for higher RWA. If Basel requires regulatory capital of 8%, then you'd need $16 rather than $8, if RWA is $200 (riskier) than $100 RWA. In this way, RWA is left-hand side B/S assets but weighted more for higher risk.

Risk capital is on the right hand side and it is the equity plus any some of the sources of capital that does not strictly need to get repaid in some near-term time-frame; i.e., the non fixed obligations. Loosely, it is also called economic capital and therefore compares to the regulatory capital in Basel's requirement to hold (regulatory capital)/RWA > 8.0%. So you can see how it relates. The higher the RWA then the more risk (regulatory or economic) capital the bank will hold. I hope that's helpful!