Internal Ratings-Based Approach for Credit Risk Explained

The internal ratings-based approach (IRB) is a method banks use to assess credit risk. This approach requires banks to develop their own credit risk models to estimate the likelihood of default for their borrowers.

Banks use these models to assign internal ratings to their borrowers, which reflect the level of credit risk associated with each loan. These internal ratings are then used to calculate regulatory capital requirements.

The IRB approach is more complex and time-consuming than the standard approach, but it allows banks to use their own credit risk models and internal ratings to assess credit risk. This can be beneficial for banks that have a large and diverse portfolio of loans.

Credit risk is a critical aspect of banking, and understanding its basics is essential for any financial institution. Credit risk refers to the possibility that a borrower may default on a loan or other debt obligation.

To calculate credit risk, banks must use advanced systems, such as those mentioned in § 1240.123, to determine credit risk capital requirements for various exposures. This includes general credit risk, default fund contributions, unsettled transactions, and the fair value adjustment to reflect counterparty credit risk in valuation of OTC derivative contracts.

A bank's rating system is a crucial tool for quantifying and assigning risk parameters. A rating system must be designed based on two dimensions: borrower characteristics indicating the propensity of the borrower to default, and transaction-specific factors like the nature of the product, terms of repayment, collateral, etc.

For retail exposures, a bank must have a minimum of seven borrower grades for non-defaulted exposures and one for those that default. This helps to avoid excessive concentration of borrowers in one particular grade.

A bank's rating system must be clear and well-documented, enabling a third party to replicate the assignment of ratings and their appropriateness. All relevant up-to-date information must be used in the assignment of ratings, and a bank must be conservative in its estimates if there is a lack of data to accurately quantify the risk parameters.

A bank can use credit scoring models to estimate risk parameters, but sufficient human judgment must be taken into account to assign the final rating to a borrower. The data used to build these models must be representative of the bank's exposures, and there must be no distortion in the calculation of regulatory capital due to the use of these models.

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The foundation approach is a method used to calculate capital requirements for banking exposures. This approach requires banks to calculate their own PD parameter, while the other risk parameters are provided by the bank's national supervisor.

There are three main elements to consider when using the foundation approach: risk parameters, risk-weight functions, and minimum requirements. Banks need to meet these minimum guidelines to use this approach.

However, the foundation approach is not available for Retail exposures, which means banks can't use this method for customer loans or credit card debt.

For equity exposures, banks have two options to calculate risk-weighted assets not held in the trading book: a PD/LGD approach or a market-based approach.

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Internal ratings are a crucial part of a bank's risk management strategy. A rating system must be designed based on two dimensions: borrower characteristics indicating the propensity of the borrower to default and transaction-specific factors like the nature of the product, terms of repayment, collateral, etc.

To avoid excessive concentration of borrowers in one particular grade, a bank must have a minimum of seven borrower grades for non-defaulted exposures and one for those that default. For retail exposures, banks should be able to quantify the risk parameters for each pool of exposures.

Banks must satisfy the 'use test', which means that the ratings must be used internally in the risk management practices of the bank. A rating system solely devised for calculating regulatory capital is not acceptable.

A bank must use a conservative approach when estimating risk parameters, especially if there is a lack of data. Credit scoring models can be used, but sufficient human judgment must be taken into account to assign the final rating to a borrower.

Banks must regularly review and update their rating systems to ensure they remain accurate and effective. This includes reviewing the data used to build credit scoring models and ensuring they are representative of the bank's exposures.

Here are the key characteristics of a good internal rating system:

These characteristics are essential for a bank to demonstrate to its national supervisor in order to adopt and continue using the IRB approach.

The Standardized Approach is a simpler way of measuring credit risk compared to the IRB approach. It uses prescribed risk weights based on observable risk characteristics to determine minimum capital requirements.

For residential mortgage exposures in Australia, risk weights are based on the loan-to-valuation ratio, whether the loan is standard or non-standard, and whether it's covered by lenders mortgage insurance.

In Australia, residential mortgage exposures can attract a risk weight of 35, 50, 75, or 100 per cent, depending on the mix of characteristics.

Here's a breakdown of the possible risk weights for residential mortgage exposures in Australia:

APRA's prudential standard applies more risk-sensitive criteria than some other jurisdictions, which can result in different risk weights for the same mortgage exposures under the IRB approach.

The internal ratings-based approach (IRB) is a risk management framework used by banks to estimate credit risk. Banks must satisfy the 'use test', which means that the ratings must be used internally in the risk management practices of the bank.

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A rating system solely devised for calculating regulatory capital is not acceptable. Banks are encouraged to improve their rating systems over time, but they are required to demonstrate the use of risk parameters for risk management for at least three years prior to obtaining qualification.

To adopt the IRB approach and its continued use, a bank must satisfy certain minimum requirements. These include estimates of risk parameters that reflect borrower and transaction characteristics, provide for meaningful differentiation of risk, and be accurate and consistent in the estimation of risk.

Banks have specific requirements when it comes to internal ratings. Loans made to banks or securities firms subject to regulatory capital requirements fall under this category.

Banks that are subject to regulatory capital requirements must use a rating system that accurately reflects their credit risk. This includes domestic PSEs or MDBs that do not meet the criteria for a 0% risk weight under the standardized approach.

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A bank's rating system must be regularly stress tested to ensure it can withstand economic downturns, market risk events, or liquidity conditions. This includes considering both internal data and macro-economic factors.

Banks must also regularly review their rating systems to ensure they are accurate and consistent. This includes reviewing the risk parameters used in the system and making any necessary adjustments.

Banks must also meet the disclosure requirements as mandated by the third pillar of the Basel framework.

A well-designed rating system is crucial for effective internal ratings. It must be based on two dimensions: borrower characteristics indicating the propensity of the borrower to default, and transaction specific factors like the nature of the product, terms of repayment, collateral, etc.

Banks are allowed to use multiple ratings systems for different exposures, but the methodology of assigning an exposure to a particular rating system must be logical and documented. This ensures that the system is fair and accurate.

To avoid excessive concentration of borrowers in one particular grade, a bank must have a minimum of seven borrower grades for non-defaulted exposures and one for those that default. This helps to ensure that the risk is spread evenly across different grades.

For retail exposures, delinquent exposures should be identified separately from those that are not. This helps to better understand the risk associated with each type of exposure.

A rating system must be clear and well-documented, enabling a third party to replicate the assignment of ratings and their appropriateness. All relevant up-to-date information must be used in the assignment of ratings.

Here are the key requirements for a rating system:

Banks must also have a system governing the use of credit scoring models, ensuring that sufficient human judgment is taken into account to assign the final rating to a borrower. This helps to ensure that the rating system is accurate and reliable.

Corporate exposure is a crucial aspect of internal ratings, and understanding how it's calculated can help banks make informed decisions.

The exposure for corporate loans is calculated as follows, taking into account the probability of default, loss given default, and exposure at default.

To determine the credit risk capital requirement, banks must use advanced systems to determine the credit risk for each exposure, including general credit risk and default fund contributions.

The credit-risk-weighted assets calculated under the advanced approach equals the aggregate credit risk capital requirement multiplied by 12.5.

Banks can categorize corporate exposures into one of five sub-classes: industrial, commercial, financial, real estate, or other.

These sub-classes have different risk weights and treatment, which can affect the credit risk capital requirement.

Banks can determine their own estimation for some components of risk measure, such as the probability of default, loss given default, and exposure at default.

For public companies, default probabilities are commonly estimated using the structural model of credit risk proposed by Robert Merton or reduced form models like the Jarrow–Turnbull model.

Banks can use credit scoring or logistic regression to estimate default probabilities for retail and unlisted company exposures.

The goal is to define risk weights by determining the cut-off points between and within areas of the expected loss and the unexpected loss, where the regulatory capital should be held.

Here are some formulae for calculating risk weights for corporate exposures:

A firm seeking to apply the Standardised Approach on a permanent basis must have a well-documented policy explaining the basis for selecting exposures for permanent exemption from the IRB approach.

This policy should be provided to the PRA when the firm applies for permission to use the IRB approach and maintained thereafter.

For firms that are members of a group, the PRA expects the 15% test to be applied at the group level.

Exposures to sovereigns and institutions can be exempted from the IRB approach if the number of material counterparties is limited and it would be unduly burdensome to implement a rating system.

The PRA considers a trading book within the firm's group as an adequate proxy for the likely level of expertise available to implement a rating system.

If a firm's group does not have a trading book, the PRA is likely to accept the argument that it would be unduly burdensome to implement a rating system.

To adopt the IRB approach, a bank must satisfy certain minimum requirements that it can demonstrate to the national supervisor. These requirements are described in twelve sub-sections.

The minimum requirements state that estimates of risk parameters must reflect borrower and transaction characteristics, provide for meaningful differentiation of risk, and be accurate and consistent in the estimation of risk. The risk parameters must also be consistent with their use in making risk management decisions.

Banks must meet the disclosure requirements as mandated by the third pillar of the Basel framework. Failure to meet these requirements makes the bank ineligible to use the IRB approach.

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To recognize leasing, leases other than those that expose the bank to residual value risk are accorded the same treatment as exposures collateralized by the same type of collateral.

Banks must meet the disclosure requirements as mandated by the third pillar of the Basel framework.

To meet these requirements, banks need to follow specific guidelines to ensure they are eligible to use the IRB approach.

Failure to meet these requirements makes the bank ineligible to use the IRB approach.

The PRA expects firms to take into account all instances of non-compliance with the requirements of the IRB approach.

Firms seeking to demonstrate that the effect of their non-compliance is immaterial must provide a thorough assessment of their non-compliance under CRR Article 146(b).

This involves demonstrating that the overall effect of non-compliance is immaterial, not just a single instance of non-compliance.

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In the UK, groups applying the IRB approach on a unified basis are subject to specific requirements. The PRA requires that certain IRB requirements be met on a collective basis by members of the group.

To meet this condition, the firm must use the IRB approach on a unified basis, meaning it must not rely on a rating system or data provided by another group member unless it meets certain criteria. The PRA considers that this will only be the case if the firm only does so to the extent that it is appropriate, given the nature and scale of the firm's business and portfolios and the firm's position within the group.

The firm's systems and controls must also not be adversely affected by outsourcing these functions. The PRA expects the proposed arrangements to have been explicitly considered and found to be appropriate by the governing body of the firm before reliance is placed on a rating system or data provided by another group member.

The PRA also requires that the outsourcing of these functions meets the requirements of SYSC, and that the abilities of the PRA and the lead regulator of the group to carry out their responsibilities under the CRR are not adversely affected.

Here are the key conditions for using a rating system or data provided by another group member:

The firm's governing body must also delegate those functions formally to the persons or bodies that are to carry them out.