Risk-weighted assets are the denominator in the calculation to determine the solvency ratio under the provisions of the Basel III final rule. The solvency ratio, known as the risk-based capital ratio, is calculated by taking the regulatory capital divided by the risk-weighted assets. The solvency ratio determines the minimum amount of common equity banks must maintain on their balance sheets.
Risk-weighted assets are a financial institution's assets or off-balance-sheet exposures weighted according to the risk of the asset. Basel III increased the amount of common equity the banks must hold. For example, under Basel III, banks are required to hold 4.5% of common equity of risk-weighted assets, with an additional buffer of 1.5%. The common equity percentage increased from Basel II, which only required 2%.
Basel III is a comprehensive regulatory measure passed in the wake of the 2008 credit crisis that seeks to improve risk management for financial institutions. Basel III changed how risk-weighted assets are calculated. Under Basel III, U.S. government debt and securities are given a risk weight of 0%, while residential mortgages not guaranteed by the U.S. government are weighted anywhere from 35 to 200% depending on a risk assessment sliding scale. Under Basel II, residential mortgages had a flat risk weighting of 100% or 50%.
Basel III increased the risk weighting for certain bank trading activities in particular, especially swaps trading. Some argue that Basel III has placed undue regulations on banks for these trading activities and has allegedly reduced their profitability. Basel III encourages the trading of swaps on centralized exchanges to reduce counterparty default risk, often cited as a major cause of the 2008 financial crisis. In response, many banks have severely curtailed their trading activities or sold off their trading desks to non-bank financial institutions.