2.2 Internal-Rating Based Approaches

Course week(s) Week 2
Course subject(s) Approaching Credit Risk

The Standardized Approach (STA, also spelled “Standardised”) is the topic of this lesson.
It is completely described in the Basel II document, which you can find here.
In particular, the relevant pages are 19-51.
You are not supposed to study these pages, but I strongly suggest you to have a look.
It may be sufficient to read pages 19-20, to have an idea of how these documents are written.

The internal-rating based (IRB) approaches are more sophisticated than the standardized approach, and they require more work and attention. However, on average, capital requirements, as obtained from IRB methods, are smaller than those given by the standardized approach (and this is something banks do like, because in this way they have more money for other activities). This is due to a more accurate computation of the RWA. Under the IRB approach, the RWA is obtained using very specific formulas, different from the one we have seen in Lesson 1. We will see those formulas later on, when introducing the different models.

Under the IRB approaches, the RWA is generally computed using 3 different elements:

  1. Risk parameters
    The most famous ones are: the Probability of Default (PD), the Exposure at Default (EAD), the Loss Given Default (LGD), and the so-called Maturity (M).
  2. Risk-weight functions
    These are functions defined in the Basel II-III Accords, and they are meant to compute the RWA given the risk parameters of the previous point.
  3. Minimum requirements
    Simply the minimum standards a bank must comply with, in order to be authorized to the use of the IRB methods.

As you already know, there are two main approaches in the IRB family:

  • The Foundation approach, or F-IRB
    In the F-IRB, banks can compute the probabilities of default (PD) of their counterparties, using the methods they prefer. The formulas to compute all the other risk parameters are provided by the national regulator, according to the rules of Basel II and III.
  • The Advanced approach, or A-IRB
    In the A-IRB, banks are free to calculate all their risk parameters using proprietary models. The only condition is that computations respect some minimum guidelines, which are set by the regulator.
    The regulators also checks the statistical soundness of the proposed models.

Regarding the IRB approaches, you can have a look at pages 52-119 of the Basel II document, but no need to study it!

Internal-Rating Based Approaches

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Introduction to Credit Risk Management by TU Delft OpenCourseWare is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.
Based on a work at https://ocw.tudelft.nl/courses/introduction-credit-risk-management/.
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