Why are risk-weighted assets used in capital adequacy calculations?

• A. It is used to maximize bank profits
• B. It ignores asset risk
• C. It adjusts asset values by credit and market risk so capital requirements reflect risk
• D. It measures only liquidity risk

Answer: (C)

The main idea is to tie capital to the riskiness of a bank’s assets. Risk-weighted assets are created by adjusting the value of different assets according to their credit and market risk, so the capital a bank must hold better reflects how vulnerable it is to losses. Loans and exposures with higher risk get higher weights, while safer assets get lower weights. This lets regulatory capital requirements scale with how risky the balance sheet is, rather than just its size.

Because of this, the capital ratio measures regulatory capital relative to risk-weighted assets, not raw assets. It promotes safety and resilience by ensuring banks hold more capital for riskier activities. It doesn’t focus on maximizing profits, ignore risk, or measure liquidity risk—that broader liquidity side is handled separately.