You call it WRA, I call it RWA. What does it all mean ? Risk weighted assets are a fictitious concept that is used to measure a Bank's capital. To understand what this is, let us first understand how a Bank holds capital.
Simple example. Depositors put a million in my bank, I lend out nine hundred thousand. A hundred thousand is my safety net. I take in ten such deposits and I lend out ten such loans and I am sitting on a million bucks as reserve. I am playing a game here, because as long as all ten of my depositors do not come asking for money, I am good to cover the one guy that shows up. This is the traditional banking model.
Now if I do a derivative with one counterparty, and I do an offsetting derivative with another counterparty, do I need capital ? Not at the beginning, because in the beginning the derivative has no value. But as the market moves and the derivative has value, I am effectively lending to one guy and borrowing from the other. So, similar to my above simple example, I need to hold capital. This is where RWA -risk weighted asset comes in. If the value of my derivative is 1Million today, I do not necessarily have to hold a 100 thousand in reserve for it. Depending on the derivative and some amorphous rules, I am free to come up with a black box model, that will tell me how much reserve to hold. This number could be zero, could be ten bucks or could be a million. The beauty of it is that it is entirely up to me to calculate this number. This is the RWA for this contract. So I take some vaguely estimated probability of default, and multiply it by an equally made up loss given default, and come up with a perfectly random number. The smaller this amount that I need to hold in reserve, the more profitable I will look.
So now let us look at a scenario, where we have ten large investment banks, all doing a simple product like a fixed to floating swap. Nevermind credit default swaps. They are all producing the same simple widget. It was invented a long time ago and one widget is as good as another. You cannot even pretend that a swap produced by Goldman sachs smells any sweeter than that produced by the creit union down the corner. So, the only way to be more profitable than the other guy, besides selling snake oil to unsuspecting widows, Municipalities etc (adding a few extra bps when they are not looking) is for the wizards to play with the RWA numbers. The more profits you squeeze out of less capital, the better you look. The skill is in the capital management or the number management.
And we are so shocked that these banks were so thinly capitalized during the crisis! Look at the capital they hold against trillion dollar balance sheets. My advice to regulators - Force Banks/Investment Banks to hold more capital. Dont buy their stupid Value at risk VAR nonsense. Anybody with half a brain knows that Var is not real finance. VAR is like looking for inner beauty at a Miss America Pageant . True risk management is Credit risk Management. How much due diligence did you do when you lent out the firm's money to a perfect stranger ? That is the true essence of a Banker. Good judgement and hard work done before lending out money. You dont learn that in a crash course case study at an Ivy league MBA.
And these whiners actually want to say the rating agencies made me buy all those crap securities. Only a regulator or a Bloomberg correspondent would buy that kind of BS.
The BASEL II & BASEL infinity versions are supposed to solve the RWA problem. That is laughable. They set a blind elephant to hunt down a very lithe cheetah, in a particularly dark part of the forest. No hope of them catching anything before the next crisis. It is really touching though the faith that people put in these silly charms to ward off the evil eye. Like for instance the Sarbanes Oxley controls to prevent Accounting scandals. That SOX thing really worked man - except for Lehman, Bear Stearns and the rest of them.
