Risk-Weighted Assets

Banks have to answer to a lot of regulators. They have to keep their risks in check and make sure they have substantial reserves for every potential emergency.

In making these calculations, the bank needs to estimate the possibility that a particular loan might go south. When adding up its assets, the financial institution has to keep in mind that each loan, each investment, might go bust.

The process of considering these chances of default leads to the idea of a risk-weighted asset. Each asset is assigned a level of risk. That risk assessment plays into the value given the asset, while adding up the amount of capital held by the bank, and in determining whether it's adequately buffered against potential insolvency.

The math that goes into calculating a risk-based asset's value can get complicated. But, as a simplified example, assume one $10 million loan has a 10% chance of default. Another $10 million loan has a 20% chance of default. When added to the balance sheet of the bank, the first loan would get credited as $9 million and the second would get credited as $8 million. Even though they nominally have the same value, the first is worth more once its risk-weighting gets taken into account.

(Again, the math here is severely simplified...but you get the gist.)