Internal ratings-based approach (credit risk)

The Internal Ratings-Based (IRB) approach is a method for calculating regulatory capital for credit risk under the Basel II and Basel III frameworks. It allows banks to use their own internal models to estimate the probability of default (PD), loss given default (LGD), and exposure at default (EAD) of their assets. These estimations, along with regulatory parameters, are then used to determine the amount of capital a bank must hold to cover potential credit losses.

The IRB approach is considered a more sophisticated and risk-sensitive method than the standardized approach, as it relies on the bank's own assessment of its credit portfolio. However, it also requires a higher level of data quality, analytical capabilities, and validation procedures.

There are two main types of IRB approaches:

• Foundation IRB (FIRB): Under the FIRB approach, banks estimate the probability of default (PD) for each obligor, while the regulatory authorities provide the LGD, EAD, and maturity assumptions.

• Advanced IRB (AIRB): Under the AIRB approach, banks estimate PD, LGD, and EAD for each obligor, subject to regulatory approval. Banks may also be permitted to estimate the effective maturity (M). The AIRB approach requires more sophisticated modeling and data capabilities than the FIRB approach.

To be eligible to use the IRB approach, banks must meet certain minimum requirements related to their risk management systems, data quality, and model validation. These requirements are designed to ensure that banks' internal models are accurate and reliable.

Key benefits of the IRB approach include:

• More risk-sensitive capital requirements: The IRB approach allows banks to tailor their capital requirements to the specific risks of their loan portfolio, potentially leading to lower capital charges compared to the standardized approach for well-managed portfolios.
• Improved risk management: The process of developing and implementing IRB models can help banks to better understand and manage their credit risk.
• Enhanced competitive advantage: Banks that can accurately assess their credit risk may be able to offer more competitive pricing on loans.

However, the IRB approach also has some drawbacks:

• Complexity and cost: Developing and implementing IRB models can be a complex and expensive undertaking.
• Model risk: The accuracy of the IRB approach depends on the quality of the data and the validity of the models used.
• Regulatory scrutiny: Banks using the IRB approach are subject to intensive regulatory scrutiny.

The implementation and ongoing use of the IRB approach require significant resources and expertise, and banks must demonstrate to their regulators that they meet the required standards.