What it means
Banks are unusual: their balance sheets are enormous relative to their profits, and two assets of the same size can carry completely different risk. Regulation therefore assigns each asset a risk weight, and the weighted total becomes the base against which capital requirements are set.
RORWA takes that same regulatory base and asks what return the bank generates on it. The measure has become a standard internal yardstick because capital, not deposits, is the scarce resource in modern banking.
A lending team winning volume at thin margins can look busy while consuming capital that earns nothing, and RORWA is the number that shows it. It is calculated as net income divided by risk-weighted assets, usually averaged across the period.
Because risk-weighted assets are smaller than total assets for almost every bank, RORWA is always higher than plain return on assets. Figures for a healthy commercial bank typically sit somewhere between 1% and 2%.
Business lines are often steered by the measure directly, with pricing floors set so that any new loan clears a minimum RORWA hurdle. That pushes banks towards products consuming less regulatory capital, such as secured lending and fee income, and away from cheaply priced unsecured corporate exposures.
The main criticism is that risk weights come from rules and models rather than from markets, so they can lag reality badly. Two banks holding similar portfolios can report different risk-weighted assets if one uses approved internal models and the other the standard tables.
Comparisons across countries and across model approaches therefore need care.
In practice
Real-world examples.
Example
A bank's pricing committee reviews a $200,000,000 unsecured facility for a corporate client at a margin that would produce a RORWA of 0.6%. Because the internal hurdle is 1.2%, the committee either reprices the deal or asks for security that reduces the risk weight.
Example
A retail bank shifts its growth plan from unsecured personal loans towards low loan-to-value mortgages. Reported profit growth slows, but RORWA improves because each new mortgage consumes roughly half the risk-weighted assets of the loans it replaced.
Example
A bank's board compares two divisions with similar profits. The wealth management arm, which earns fees and holds few risky assets, shows a RORWA several times higher than the corporate lending arm, and capital is reallocated accordingly.
Think of it
“RORWA shows bank profits relative to the riskiness of assets-risk-adjusted returns.
Formula
Calculation
RORWA = Net income / Risk-weighted assets
A mid sized commercial bank holds $5,000,000,000 of cash and government bonds at a 0% risk weight, $20,000,000,000 of residential mortgages at a 50% weight, and $18,000,000,000 of corporate loans at a 100% weight.
Risk-weighted assets = $0 + ($20,000,000,000 x 0.50) + $18,000,000,000 = $10,000,000,000 + $18,000,000,000 = $28,000,000,000.
The bank reports net income of $420,000,000 for the year.
RORWA = $420,000,000 / $28,000,000,000 = 0.015, or 1.5%.
Total assets are $5,000,000,000 + $20,000,000,000 + $18,000,000,000 = $43,000,000,000, so return on assets is $420,000,000 / $43,000,000,000 = 0.98%. The gap between 0.98% and 1.5% is explained entirely by the low risk weighting of the cash, bonds and mortgage book.Case study
Seen in the real world.
Northbrook Mutual Bank is a fictional institution used here as an illustrative example. Its regional lending teams were rewarded on loan book growth, and the book had grown 40% in three years while profit rose only 8%.
The new chief financial officer introduced RORWA reporting for every team. One region had built a large portfolio of unsecured small business loans at a margin that produced a RORWA of 0.4%, against a group average of 1.3%, because those loans carried a full 100% risk weight and needed a matching slice of capital. In effect the region had been growing by selling risk too cheaply.
In this fictional case the bank left the loans in place but changed the incentive, paying bonuses on RORWA rather than on volume. New lending shifted towards secured and partly guaranteed structures, and group RORWA rose from 1.3% to 1.6% over two years without any increase in the size of the balance sheet.
Watch out
Common mistakes.
- Comparing a bank's RORWA directly with a manufacturer's return on assets, when the two measures are built on completely different bases.
- Assuming a rising RORWA always means better performance, when it can simply reflect a change in the risk weights the regulator applies.
- Ignoring fee income, which generates profit with little or no addition to risk-weighted assets and therefore lifts the ratio.
Questions
People also ask.
Why not just use return on assets for banks?
Because two banks with identical total assets can carry wildly different risk, and return on assets treats a government bond and an unsecured loan as the same thing.
How does RORWA relate to return on equity?
Regulatory capital is set as a percentage of risk-weighted assets, so RORWA multiplied by the ratio of risk-weighted assets to equity gives a close approximation of return on equity.
Is a higher RORWA always safer?
No, it may mean a bank is earning well on risky lending, so the ratio should always be read alongside capital ratios and loan loss figures.
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