Complications in Bank Valuations  753 Risk-Weighted Assets and Equity Risk Capital Banks are required to hold a minimum level of equity capital that can absorb potential losses to safeguard the bank’s obligations to its customers and finan- ciers. In December 2010, new regulatory requirements for capital adequacy were specified in the Basel III guidelines, replacing the 2007 Basel II accords, which were no longer considered adequate in the wake of the 2008 and 2010 financial crises.15 The new guidelines are being gradually implemented by banks across the world between 2013 and 2022. Basel III specifies rules for banks regarding how much equity capital they must hold based on the bank’s so-called risk-weighted assets (RWA).16 The level of RWA is driven by the riskiness of a bank’s asset portfolio and its trad- ing book. Banks have some flexibility to choose either internal risk models or standardized Basel approaches to estimate their RWA. All such models rest on the general principle that the total RWA is the sum of separate RWA estimates for credit risk, market risk, and operational risk. However, banks do not publish the risk models they use. If you are conducting an outside-in valuation, you need an approximation of a bank’s future equity risk capital needs. Because banks typically provide information on total RWA but not on the risk weighting for its asset groups, trading book, and operations, you have to make an approximation of the key categories’ contribution to total RWA for the bank in order to project RWA and risk capital for future years.17 Exhibit 38.13 shows such an outside-in approximation of RWA for a large European bank. The bank separately reports the total RWA for credit risk, market risk, and operational risk. • To approximate the RWA for credit risk, you can use the risk weights from the Basel II Standardized Approach (see Exhibit 38.14) and information on the credit quality of the bank’s loans. Estimate the risk weighting and RWA for each of the loan categories in such a way that your estimate fits the reported RWA for all loans (€202 billion in this example). • Market risk is a bank’s exposure to changes in interest rates, stock prices, currency rates, and commodity prices. It is typically related to its value at risk (VaR), which is the maximum loss for the bank under a worst- case scenario of a given probability for these market prices. For an ap- proximation, use the reported VaR over several years to estimate the bank’s RWA as a percentage of VaR (242 percent in the example). 15 The Basel accords are recommendations on laws and regulations for banking and are issued by the Basel Committee on Banking Supervision (BCBS). 16 In addition, Basel III sets requirements for liquidity and restrictions on leverage in the form of a minimum liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) and a threshold leverage ratio (LR). We focus here on capital adequacy, as that is typically the most critical requirement to take into account when valuing a bank. 17 Without RWA estimates by business line, you could only project the bank’s risk capital for a scenario in which all business lines grow at the same rate. 754  Banks EXHIBIT 38.13  Estimating Risk-Weighted Assets (RWA) for a Large European Bank € billion Reported RWA Estimated RWA parameters Year Asset category Loans outstanding RWA Standardized RWA/loans, % Standardized RWA Allocated RWA Estimated RWA/ loans, % Credit risk 2013 Loans to countries 16,228 10 1,623 2,220 14 Loans to banks 25,100 35 8,785 12,016 48 Loans to corporations 147,242 35 51,535 70,486 48 Residential mortgages 148,076 35 51,827 70,885 48 Other consumer loans 45,440 75 34,080 46,613 103 Overall 382,086 202,219 147,489 202,219 53 Year VaR trading book RWA Estimated RWA/ VaR Market risk 2013 19,564 47,259 242% Year Revenues RWA Estimated RWA/ revenues Operational risk 2013 32,826 50,891 155% Exhibit 38.14  Risk Weights in Basel II Standardized Approach % Asset category Credit risk AAA to AA– A+ to A– BBB+ to BBB– BB+ to BB– B+ to B– Below B– Unrated Loans to countries – 20 50 100 100 150 100 Loans to banks 20 50 50 100 100 150 50 Loans to corporations 20 50 100 100 150 150 100 Residential mortgages Local regulator flexibility: Mortgages with low loan-to-value ratio, 35%; otherwise, 100% Other consumer loans Risk weighting of 75% • Operational risk is all risk that is neither market nor credit risk. It is usu- ally related to a bank’s net revenues (net interest income plus net other income). Use the bank’s average revenues over the previous year(s) to estimate RWA per unit of revenue (155 percent in the example). Based on your forecasts for growth across different loan categories, VaR re- quirements for trading activities, and a bank’s net revenues, you can estimate the total RWA in each future year. Basel III establishes stricter rules for banks regarding how much capital they must hold based on their level of RWA. Requirements are defined for the bank’s so-called common-equity Tier 1 (CET1), additional Tier 1, and Tier 2 capital levels, relative to RWA. Of these capital ratios, CET1 to RWA is typically the most stringent. The total minimum CET1 requirements for a