Capital Requirement for Credit Risk

We know that a certain amount of capital is required to be kept against risky assets. We have also discussed that there are three approaches to determine the capital required:

1. Standardized Approach (SA)
2. Internal ratings Based (IRB) Approach, which in turn has two approaches a) Foundation Internal Ratings Based (F-IRB) Approach b) Advanced Internal Ratings Based (A-IRB) Approach

Let’s talk about these concepts now.

Standardized Approach:

In this approach, the PD, LGD, and EAD are externally provided by agencies such as Fitch Ratings, S&P Global, FICO Credit Score, etc. These agencies give ratings to the borrowers like AAA or B-, etc. and accordingly the capital is required to be kept. Another example is FICO score, for individuals this score is in the range of 300-850 and the lower the score, the higher the credit risk and vice-versa.

Calculating the capital requirement under SA is based on the Risk weight being assigned to the ratings. For example, if the residential mortgages capital requirement is to be assessed, the risk weight is 35%. However, this approach is common for all and not specific to case by case basis. Also, can you see another point arising out of it?

Well of course, since it is not specific, banks may be required to hold more capital than they are required to, given that each case is unique.

So, then the banks can follow either F-IRB or A-IRB approach.

In F-IRB approach the PD is internally estimated while they get LGD and EAD from externally provided agencies (same as SA).

In A-IRB Approach, all three, i.e., PD, LGD, and EAD are estimated internally.

Now, we know why we need more precise estimation of the Expected Loss (PD, LGD< and EAD) i.e., due to capital reserve.

So, among SA, F-IRB, and A-IRB, definitely A-IRB is the winner!

Yay!!

Now, my dear students, we’ll have deeper understanding of the concepts ahead.

So, buckle up and lots of love ❤ ❤