International banking regulations set forth in the Basel Accords require that institutions maintain a certain amount of capital relative to the amount of risk-weighted assets (RWA) they have.
Conservative investments such a treasury notes have a risk weighting of zero, while corporate bonds have a weighting of .20, and so forth.
The exact weighting system is laid out in Basel agreements. The system is designed to reveal a bank’s level of exposure to potential losses, and the capital requirements are there to balance out the risks and to protect the global economy from a meltdown in the financial system.
The previously existing systems for regulating reserve requirements for banks did not adequately take the relative risks of different assets and liabilities into account. Today’s required Capital Asset Ratio and Capital to Risk Weighted Assets Ratio are the banking system’s best efforts to adequately account for the various levels of risk present and to maintain an adequate buffer.
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