Internal Ratings-Based Approach (Credit Risk)

Under the Basel II guidelines, banks are allowed to use their own estimated risk parameters for the purpose of calculating regulatory capital. This is known as the internal ratings-based (IRB) approach to capital requirements for credit risk. Only banks meeting certain minimum conditions, disclosure requirements and approval from their national supervisor are allowed to use this approach in estimating capital for various exposures.

The IRB approach relies on a bank's own assessment of its counterparties and exposures to calculate capital requirements for credit risk. The Basel Committee on Banking Supervision explained the rationale for adopting this approach in a consultative paper issued in 2001. Such an approach has two primary objectives -

To use this approach, a bank must take two major steps:

The regulatory capital for credit risk is then calculated as 8% of the total RWA under Basel II.

Each banking exposure is categorized into one of these broad asset classes:

These corporate and retail classes are further divided into five and three sub-classes, respectively. In addition, both these classes have a separate treatment for purchased receivables, which might apply subjectivity to certain conditions.

The following paragraphs describe the asset classes in detail.

An exposure to a corporation, partnership or proprietorship falls under this category. Some special guidelines may apply if the corporation is small or medium-sized entity (SME). As noted above, there are five sub-classes of specialized lending under this asset class -

This generally refers to a loan made to a particular country. Under the Basel II guidelines, this class also includes the central banks of various countries, certain public sector enterprises (PSEs) and the multilateral development banks (MDBs) that meet the criteria for a 0% risk weight under the standardized approach.

Loans made to banks or securities firms subject to regulatory capital requirements come under this category. Certain domestic PSEs or MDBs that do not meet the criteria for a 0% risk weight under the standardized approach also fall in this category.

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