This approach involves assigning risk weights based on the internal rating of the borrowers. The ratings exercise must fulfill certain criteria to the satisfaction of the regulator. There are two options available. They are Foundation approach and Advanced Approach.
In the IRB approaches, the bank’s internal assessment of key risk parameters serves as the primary input to capital computation. The key features of this approach are:
- Capital charge computation is dependent on probability of default (PD), Loss given at default (LGD), exposure at default (ED) and effective maturity (M).
- The IRB approach computes the capital requirement of each exposure directly.
- Banks need to categorize banking book exposures into broad classes of assets. The classes of assets are corporates, sovereigns, banks, retail and equity. Within corporates and retail, there are sub-clauses, which are separately identified.
- Risk weighted assets are derived from the capital charge computation. Banks must use the risk weight functions provided by Basel II.
- IRB approach does not allow banks to determine all elements.
- Foundation and Advanced approaches differ primarily in terms of the inputs that are provided by the bank on its own estimates and those that are specified by the supervisor.
- Under the Foundation approach, as a general rule, banks provide their own estimates of PD – probability of default and rely on supervisory estimates for other risk components.
- Under the advanced approach, banks provide more of their own estimates of PD, LGD, EAD and M.
- Banks adopting IRB approach are expected to continue to use the same. A voluntary return to earlier or lower approach is permitted only in exceptional cases with prior permission from the supervisor.
The four input parameters for IRB approaches are summarized below:
|Input Parameter||Foundation IRB||Advanced IRB|
|Probability of default (PD)||Provided by bank based on own estimates||Provided by bank based on own estimates|
|Loss given default (LGD)||Supervisory values set by the Committee||Provided by bank based on own estimates|
|Exposure at default (EAD)||Supervisory values set by the Committee||Provided by bank based on own estimates|
|Maturity||Supervisory values set by the Committee
At national discretion, provided by bank based on own estimates (with an allowance to exclude certain exposures)
|Provided by bank based on own estimates (with an allowance to exclude certain exposures)|