Credit Risk Capital Allocation –
IRB Approach
Tasneem Chherawala
NIBM
Basel II Pillar 1: Minimum Capital
Adequacy Ratio
• Capital Adequacy Ratio =
Regulatory Capital Funds
-------------------------------------------------Risk Weighted Assets (On & Off B/S)
= Minimum 8%
Total Risk Weighted Assets =
12.5 X [Capital Required for Mkt risk + Operational risk + Credit
Risk]
• Credit Risk weighted assets measured for all banking book
exposures subject to default (Fund Based and Non Fund
Based)
• Within market risk, credit risk estimation for trading book
assets subject to default and mark-to-market credit losses
2
Credit Risk Approaches under Basel II
• Three Approaches for Credit Risk Capital Charge
PILLAR 1 FOR CREDIT RISK
Banks use internal estimations
of PD, loss given default (LGD)
and exposure at default (EAD)
to calculate risk weights for
exposure classes
INCREASED SOPHISTICATION
Advanced Internal
Ratings Based
Approach
Foundation Internal
Ratings
Based Approach
Standardized
Approach
Banks use internal estimations of
probability of default (PD) to calculate
risk weights for exposure classes. Other
risk components are standardized.
Regulatory Risk weights are based on
assessment by external credit
assessment institutions
REDUCED CAPITAL REQUIREMENT
RWA for Corporate Exposures –
Standardized Approach
Large Corporate Exposures (>Rs. 5 Crore)
External Ratings
AAA
AA
A
BBB
BB & Below
Unrated
Performing Assets
Total
D < 20% provision
D < 50% provision
D > 50% provision
NPA Total
Adjusted
Exposure
(Rs. Crore)
1030.0
3900.0
5064.0
11569.0
5308.0
16796.0
RW
20%
30%
50%
100%
150%
100%
RWA
(Rs. Crore)
206.0
1170.0
2532.0
11569.0
7962.0
16796.0
20.0
44.4
147.0
150%
100%
50%
30.00
44.40
73.50
Credit RWA Total
Credit Risk Capital Required (Min. 9%)
40382.90
3634.46
Exposure
(Rs. Crore)
3000.0
6000.0
6500.0
15000.0
6500.0
25000.0
Exposure
(%)
4.8%
9.7%
10.5%
24.2%
10.5%
40.3%
62000.0
40.0
74.0
196.0
310.0
100.0%
Limitations of the Standardized
Approach
• The approach does not take into consideration banks’ actual
credit risks as measured by internal parameters.
• If a large proportion of the bank’s credit portfolio is not rated
by external rating agencies, the 100% risk weight for unrated
categories may lead to overestimation of capital required
• Impact of credit risk mitigants on reducing losses and capital
charge beyond identified liquid, eligible financial collateral is
ignored
• Certain low risk retail portfolios give rise to significantly lower
capital charge under IRB Approaches as compared to the
Standardized Approach
IRB Approach for Credit Risk
• Classify the Credit Exposures into asset classes
• Obtain internal, bank specific estimates of risk components –
factors which drive credit risk
• Check whether minimum requirements are satisfied - the
minimum standards that must be met in order for a bank to
use the IRB approach for a given asset class.
• Use the regulatory Risk-weight functions - the means by
which risk components are transformed into risk-weighted
assets and therefore capital requirements.
• The Risk Weighted Asset (RWA) = Risk Weight * EAD
• The total Credit RWA = ∑ RWAi
• Credit Risk Capital = RWA * 9%
IRB Approach for Credit Risk
Categorisation of Exposures
• Classes of Assets
–
–
–
–
–
–
–
Corporate
SME
Specialised lending sub classes
Sovereign
Bank
Retail
Equity
Risk Components
• Explicit use of the risk components / risk factors to calculate
Risk Weights
– Probability of Default (PD) for borrowers in each rating grade or for
Retail Pools
– Loss Given Default (LGD) - facility specific
– Exposure at Default (EAD)
– Size Adjustment for SME Exposures
– Effective Maturity (M) for Corporate/Bank/Sovereign/SME
– Asset Correlation dependent upon PD (ρ) and asset class
• Under Foundation IRB, Banks can use own estimates of PD
only
• Under Advanced IRB, Banks can use own estimates of PD, LGD
and EAD
Risk Weight Function
Risk Weight Function for Corporate, Bank and Sovereign
Exposures excluding SL
Impact of PD on Risk Weights
• For large corporate, sovereign and bank exposures, PD estimates must be
differentiated by internal rating categories
• For retail portfolios, internal estimates of Pooled PD can be applied to the
portfolio exposure as a whole
• Minimum 5 years of historical data should be used to estimate rating wise
and pooled PD
Internal Rating
Category
AAA
AA
A
BBB
BB
B
C
PD Estimate
0.03%
0.15%
0.51%
1.10%
2.19%
5.00%
Risk Weight
14.44%
37.42%
70.24%
95.47%
117.79%
149.85%
10.00%
193.09%
RWA for Corporate Exposures – IRB
Approach
Large Corporate Exposures (>Rs. 5 Crore)
Internal Ratings
AAA
AA
A
BBB
BB
B
C
Unrated
Performing Assets
Total
D < 20% provision
D < 50% provision
D > 50% provision
NPA Total
RW
13%
33%
62%
85%
105%
133%
172%
100%
RWA (Rs.
Crore)
1540.6
5322.5
9053.0
11031.7
4711.7
1998.1
858.2
0.0
150%
100%
50%
54.00
44.40
24.50
Credit RWA Total
Credit Risk Capital Required (Min. 9%)
Capital Savings compared to the Standardized Approach
34638.63
3117.48
514.73
EAD (Rs. Crore)
12000.0
16000.0
14500.0
13000.0
4500.0
1500.0
500.0
0.0
EAD (%)
1.9%
2.6%
2.3%
2.1%
0.7%
0.2%
0.1%
0.0%
62000.0
40.0
74.0
196.0
310.0
10.0%
Net Exposure
(Rs. Crore)
36.0
44.4
49.0
RWA for Retail Portfolio – IRB
Approach
Retail Residential Mortgage / Housing Loans
Exposures
Housing Loans Pooled PD
Housing Loans LGD
EAD (Rs. Crore)
Correlation (R)
K (per Rs.)
1.00%
45.00%
15000
0.15
4.51%
Risk Weight (%)
50.13%
Risk Weighted Assets (Rs. Crore)
7519.86
Minimum Credit Risk Capital (Rs. Crore)
Capital Savings Compared to Standardized Approach
676.79
54.32
Regulatory Capital Requirements
under Different Basel Approaches
Transition to Foundation IRB can reduce capital requirements for
Credit Risk by 16.29% and Transition to Advanced IRB can reduce it
by 29%
IRB Capital is Primarily for Unexpected
Losses
• The Basel II IRB formulae set credit risk capital the difference
between large potential losses at a high confidence level over a one
year horizon (Value at Risk) and Expected Loss
• Under Basel II, capital is set to maintain a supervisory fixed
confidence level (99.9%).
• Thus, the IRB capital requirements cover mainly Unexpected Loss.
• The regulatory requirement is that Expected Losses are therefore
adequately covered by provisions
• Thus, banks adopting the IRB Approach will need to compare the
stock of standard asset provisions with Expected Loss calculated
based on IRB parameters (ΣPD*LGD*EAD)
• Any shortfall must be deducted from CET1 (under Basel III)
• Any excess will be eligible for inclusion in T2 capital subject to a cap
(maximum) of 0.6% of Credit Risk Weighted Assets
Credit Risk in Pillar II ICAAP
• Credit Concentration Risk
– The standardized risk weights in the Standardized approach and
the Risk Weight formula in the IRB approach are calibrated
under the assumption of granularity of credit portfolio
– Any deviation of a bank’s credit portfolio to this granularity is
captured via presence of concentration
– Credit concentration risk leads to higher capital requirements
• Credit risk capital requirements under stress scenarios
– The Pillar I credit risk capital is computed assuming current /
“normal” circumstances
– If the economic conditions get shocked, the credit portfolio
quality may worsen, indicating the need for higher capital
requirements
ICAAP Impact on Credit Risk Capital
Stress Scenario: 3%
Large Corporate Exposures (>Rs. 5 Crore)
downgrades
Shocked
Gross
Adjusted
Adjusted
Gross Exposure Exposure Exposure
RWA
Exposure (Rs. RWA (Rs.
External Ratings (Rs. Crore)
(%)
(Rs. Crore) RW
(Rs. Crore) Crore)
Crore)
AAA
3000.0
4.8%
1030.0
20%
206.0
999.1
199.8
AA
6000.0
9.7%
3900.0
30%
1170.0
3813.9
1144.2
A
6500.0
10.5%
5064.0
50%
2532.0
5029.08
2514.5
BBB
15000.0
24.2%
11569.0
100% 11569.0
11373.85
11373.9
BB&Below
6500.0
10.5%
5308.0
150%
7962.0
5495.83
8243.7
Unrated
25000.0
40.3%
16796.0
100% 16796.0
16292.12
16292.1
Performing
Assets Total
62000.0
100.0%
43667.0
43003.88
D < 20%
provision
40.0
20.0
150%
30.00
400
600
D < 50%
provision
74.0
44.4
100%
44.40
300
300
D > 50%
provision
196.0
147.0
50%
73.50
174.52
87.26
NPA Total
310.0
211.4
874.52
Credit RWA Total
40382.90
40755.51
Credit Risk Capital Required (Min. 9%)
3634.46
3668.00
Additional Capital Required for Stress Scenarios
33.53
Additional Capital Required for Concentration Risk
27.55
ICAAP Impact on Credit Risk Capital
Large Corporate Exposures (>Rs. 5 Crore)
Internal Ratings
AAA
AA
A
BBB
BB
B
C
Unrated
Performing Assets
Total
EAD (Rs.
Crore)
12000.0
16000.0
14500.0
13000.0
4500.0
1500.0
500.0
0.0
62000.0
Net
Exposure
EAD (%) (Rs. Crore)
1.9%
2.6%
2.3%
2.1%
0.7%
0.2%
0.1%
0.0%
Stressed Scenario
RW
RWA (Rs. Crore)
13%
1540.6
33%
5322.5
62%
9053.0
85%
11031.7
105%
4711.7
133%
1998.1
172%
858.2
100%
0.0
Shocked RWA (Rs.
RW
Crore)
15.27%
1832.6
36.83%
5892.3
69.39% 10061.9
92.89% 12075.1
114.17%
5137.5
150.10%
2251.5
188.27%
941.3
100%
0.0
10.0%
D < 20% provision
40.0
36.0
150%
54.00
55.1
D < 50% provision
74.0
44.4
100%
44.40
45.1
D > 50% provision
NPA Total
196.0
310.0
49.0
50%
24.50
24.9
Credit RWA Total
34638.63
3117.48
331.08
27.55
38317.29
3448.56
Credit Risk Capital Required (Min. 9%)
Additional Capital Required for Stressed Scenario
Additional Capital Required for Concentration Risk
Additional ICAAP Requirements Under
Basel III for Standardized Approach
• For banks using the Standardized Approach for credit risk
there may be a bias to leave exposures which may potentially
get a below BB rating (and a risk weight of 150%) unrated (to
assign only a 100% risk weight) so that less capital is required
to be held against such exposures
• Under Basel III, the ICAAP must explicitly consider such
exposures and the bank must assess whether the risk weight
to which an unrated exposure is assigned is appropriate
ICAAP Buffers Under Basel III
• The supervisory review process under ICAAP would assess the
adequacy of the additional capital buffer over and above the
minimum Pillar 1 requirement maintained by each bank for
Pillar II risks
• Such a cushion should be in addition to the CCB and
Countercyclical capital buffer to be maintained according to
the applicable guidelines
• The capital buffer for Pillar II risks would generally be
reflected in more than minimum capital adequacy ratio
maintained by the bank after taking into account the CCB and
countercyclical capital buffer
Issues With IRB Implementation
• Implementation relies on risk measurement models, MIS,
infrastructure investments of the bank
• Internal Models for PD, LGD and EAD subject to strict
eligibility criteria and validation
• Arbitrage between IRB and Standardized Approach not
possible by regulatory restrictions
• For banks with demonstrable high credit quality assets, IRB
can imply significant capital savings which is an added
advantage under Basel III
• But the flip side is that if the credit quality slips, IRB
penalises with much sharper increase in capital
requirements which may become an additional burden
under Basel III
IRB Implementation Advantages Under
Basel III
• Focus on strong collateral management (to reduce LGD) and reduce
risk weights under IRB
• Focus on high credit quality assets and NPA management (to reduce
PDs) to benefit from reduced risk weights under IRB
• Apply stress tests on individual risk weight parameters like PD and
LGD as opposed to regulatory risk weights
• Undertake active portfolio diversification strategies to minimise
additional concentration risk capital requirements under ICAAP
• Refine loan pricing to reflect true expected and unexpected losses
such that the triple objectives of growth, profitability and asset
quality can be balanced
• Implement RAROC based capital allocation across business lines,
products and customers