Contrast how Basel II derives credit risk capital under the standardized approach, under the foundation IRB approach and under the advanced IRB approach.
The idea
Basel II offers three ways to compute credit risk capital. In the standardized approach the risk weight comes from the regulator's table. It depends on the exposure type and an external rating. For corporates the weight is 20 percent for AAA to AA−, 50 percent for A, 100 percent for BBB+ to BB−, 150 percent below BB−, and 100 percent if unrated. Residential mortgages get 35 percent and retail 75 percent. The two internal ratings-based (IRB) approaches need supervisory approval and use a formula driven by risk parameters. In the foundation IRB approach the bank estimates only the probability of default (PD). The supervisor supplies loss given default (LGD, 45 percent for senior unsecured), exposure at default (EAD) and maturity (2.5 years). In the advanced IRB approach the bank estimates PD, LGD, EAD and maturity itself. Retail exposures have no foundation version.
A practice question
Which approach to credit risk capital under Basel II assigns risk weights from a regulatory table based on external credit ratings?
- The standardized approach - correct
- The foundation IRB approachWhy not: Foundation IRB uses the bank's own PD estimate in a regulatory formula, not a table of external-rating weights.
- The advanced IRB approachWhy not: Advanced IRB uses the bank's own estimates of PD, LGD, EAD and maturity in the formula.
- The basic indicator approachWhy not: The basic indicator approach is an operational risk method based on gross income.
In the standardized approach the risk weight depends on the exposure class and, where relevant, an external rating. IRB approaches use internal estimates with supervisory approval.
A harder one
Under the Basel II standardized approach, a bank has these exposures: USD 100 million to a corporate rated AA, USD 80 million to a corporate rated BB, USD 60 million to a corporate rated B, and USD 40 million of residential mortgages. Use weights of 20 percent for AAA to AA-, 100 percent for BBB+ to BB-, 150 percent below BB- and 35 percent for residential mortgages. Minimum credit risk capital at 8 percent is closest to:
- USD 20.80 millionWhy not: Uses Basel I weights: 100 percent for all corporates and 50 percent for mortgages.
- USD 16.32 million - correct
- USD 13.92 millionWhy not: Caps the B-rated corporate at 100 percent; below BB- the weight is 150 percent.
- USD 18.40 millionWhy not: Gives mortgages a 100 percent weight instead of 35 percent.
RWA = 100x20% + 80x100% + 60x150% + 40x35% = 20 + 80 + 90 + 14 = 204. Capital = 8% x 204 = 16.32.
The hardest tier
A bank has IRB approval for its corporate and bank exposures and decides to use the foundation approach for them. For its residential mortgage portfolio, which statement about the IRB inputs is correct?
- The bank estimates PD only, and the supervisor supplies LGD of 45 percentWhy not: Supervisory LGD applies to foundation corporate, sovereign and bank exposures; retail IRB requires own LGD and EAD.
- The bank must estimate PD, LGD and EAD itself, because retail exposures have no foundation version - correct
- The bank must use the standardized 35 percent weight because foundation IRB excludes retailWhy not: Retail exposures may use IRB; the point is that only an advanced-style approach exists for them.
- The bank must apply the corporate maturity adjustment with M = 2.5 yearsWhy not: The retail IRB formulas have no maturity adjustment.
Under Basel II, retail IRB requires internal estimates of PD, LGD and EAD (there is no foundation option) and the retail risk-weight functions have no maturity adjustment.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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- Set out what Basel II changed, including its three pillars.
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