Basel II - Standardised Approach for Credit Risk

This approach allows banks to measure credit risk in a standardized manner based on external credit assessments. Rating agencies try to capture risk sensitivity using ratings. The risk weights are inversely related to the rating of the counter party. A higher rating indicates lower risk. National supervisors ensure the External Credit Assessment Institution (ECAI) meet the criteria set. The criteria are:

1. Objectivity
2. Independence
3. International Access
4. Transparency
5. Disclosures
6. Resources
7. Credibility

To credit rate sovereigns the country scores of Export Credit Agency are recognized.

In the case of commercial agencies two options are available. All banks under a certain country are designated a risk weight one notch below the risk weight assigned to it’s sovereign. But for countries with a credit rating of BB+ OR B- and banks of unrated countries the weights are given at 100%.

Alternatively an external credit assessment by the bank is used for its risk weights. In this case unrated banks have a risk weight of 50%.

The claims of sovereigns and their central banks are assigned risk weights as follows:

Credit Rating of Sovereigns	Risk Weight of Sovereigns	Risk Weight for banks in that country
AAA to AA- A+ to  A- BBB+ to BBB- BB+ to B- Below B- Unrated	0% 20% 50% 100% 150% 100%	20% 50% 100% 100% 150% 100%

Keeping in line with inverse risk weights and risk ratings, you will observe that weaker sovereigns or banks have risk weights far above 20%. This is unlike the earlier Basel I Accord where all sovereigns enjoyed a risk weight of 0% and banks had a uniform risk weights 20%.

In the case of corporates, claims have risk weights based on credit ratings similar to the ones given to banks in the table. The risk weights for unwanted claims are 100% .Unrated corporates cannot have risk weights lower than their sovereigns of incorporation. The supervisor should increase the standard risk weight of unrated claims when they judge that a higher risk is warranted based on default experience.

The standardized approach gives a risk weight of 75% to retail and SME exposures. The four eligibility criteria for inclusion in to the retail category are: