What does risk-based capital mean in banking?

Risk-based capital in banking refers to capital that is calculated according to the risk-weighting of a bank's assets. This concept is crucial for ensuring that banks maintain sufficient capital to cover the risks associated with their assets. Different types of assets carry varying degrees of risk, and the risk-based capital framework assigns a risk weight to these assets accordingly. For example, loans perceived as more risky may require a higher capital reserve than low-risk government securities. This approach helps to ensure that banks are adequately capitalized to absorb potential losses, promoting stability within the financial system.

Understanding risk-weighted capital is essential because it forms the foundation of regulatory requirements and encourages financial institutions to manage their capital reserves in a way that reflects the actual risk exposure they face due to their asset portfolios.