How risk weights affect bank lending

Why we produced this article

The nature of risk weights and their impact on banks’ lending behaviour is not widely understood. This article aims to provide a relatively accessible explanation of risk weights to a general audience. 

Summary of key points 

• Risk weights help determine the amount of capital a bank is required to have. Banks are required to have more capital, such as equity, for riskier loans to provide a larger buffer to absorb losses.
• Our framework for calculating risk weights is based on the internationally developed Basel framework.
• The framework offers two approaches. The Standardised approach is simple to implement but is less accurate at measuring the riskiness of a bank’s lending. The Internal Ratings Based (IRB) approach is granular and aims to more accurately assess risk, but requires significantly more modelling capability, data and resources.
• Risk weights calculated using the IRB approach are on average lower than those using the Standardised approach, but our framework includes several features to minimise any potential competitive advantages this could create.
• While theoretically risk weights can affect the supply and cost of credit provided by banks, domestic and international evidence suggests their impact is low compared to other factors.
• Lowering risk weights to promote lending in particular sectors would likely only have minor effects on loan pricing and the supply of credit. At the same time, such changes could undermine financial system resilience.