Basel Committee on Banking Supervision …

1 Basel Committeeon Banking SupervisionConsultative DocumentThe InternalRatings- based ApproachSupporting Documentto the New Basel Capital AccordIssued for comment by 31 May 2001 January 2001 Superseded documentTable of ContentsCHAPTER 1: OVERVIEW AND ORIENTATION OF IRB INTRODUCTION .. OF THE IRB approach .. SCHEMATIC OF IRB approach .. OF 5(i)Probability of Default .. 6(ii)Loss Given Default .. 6(iii) Exposure at Default (EAD) .. 6(iv) Maturity .. 7(i)Adherence to minimum requirements .. 7 CHAPTER 2: IRB FRAMEWORK FOR CORPORATE DEFINITION OF CORPORATE EXPOSURES .. OF NUMBER OF GRADES BOTH FOR PERFORMING AND NON-PERFORMING DECISION WHETHER TO FOCUS THE RATING ON THE BORROWER OR THE MEANS BY WHICH ratings ARE 10D. THE RISK FACTORS CONSIDERED IN THE RATING ASSIGNMENT 11E. THE TIME HORIZON OVER WHICH THE RATING IS CONSIDERED A VALID RISK 12F.

2 USE OF internal OF DEFAULT (PD) .. 15(i)Average PD per 15(ii)One year PD .. 16(iii) Methods for quantifying PD .. 16(iv) Impact of credit derivatives and guarantees on estimation of PD .. GIVEN DEFAULT (LGD) .. 18(i)Foundation 19(ii)LGD under the advanced approach .. AT 22(i)Transactions with uncertain future drawdown .. 23(ii)OTC derivatives .. 25(i)Introduction .. 25(ii)Treatment of maturity under the foundation IRB approach .. 26(iii) Treatment of maturity under the advanced IRB approach .. 27(iv) Definition of effective maturity .. 27(v)Information required by banks .. 28F. DISCUSSION ON DEFINITION OF 29(i)Current practice for corporate 29(ii)Reference definition of 30(iii) Prospects of a mapping for estimates based on other definitions .. WEIGHTS FOR CORPORATE EXPOSURES .. OF RISK WEIGHTED 31 Superseded FOR RWA FOR CORPORATE OF BENCHMARK RISK WEIGHTS FOR CORPORATE 33(i)Introduction.

3 34(ii)Survey- based evidence .. 35(iii) Direct estimates of risk weights .. TO CORPORATE RISK 36(i)Maturity-adjustments based on MTM approach .. 37(ii)Maturity-adjustments based on adjusted DM LOSS AND THE DETERMINATION OF CORPORATE RISK REQUIREMENTS FOR CORPORATE EXPOSURES UNDER THE FOUNDATIONAPPROACH .. TO ENSURE MEANINGFUL DIFFERENTIATION OF 42(i)Overall rating system (ii)Rating grade structure .. AND INTEGRITY OF RATING 43(i)Introduction .. 43(ii)Coverage of ratings .. 43(iii) Independent assignment or review .. OVER THE RATING SYSTEM AND 44(i)Introduction .. AND ORIENTATION OF RATING 45(i)Introduction .. 45(ii)Assessment horizon .. REQUIREMENTS FOR ESTIMATION OF PD .. COLLECTION AND IT OF internal OF KEY internal ratings OF SUPERVISORY ESTIMATES OF EAD, LGD, AND GUARANTEES/CREDIT 49(i)Requirements for 49(ii)Standards for supervisory estimates of 50(iii) Standards for supervisory treatment of guarantees/credit derivatives.

4 REQUIREMENTS FOR THE ADVANCED approach TO FOR LOSS GIVEN FOR EXPOSURE AT FOR GUARANTEES AND CREDIT EXPOSURES: KEY ISSUES WHERE FEEDBACK IS SOUGHT .. DEFINITION OF OF CORPORATE RISK 54 CHAPTER 3: IRB FRAMEWORK FOR RETAIL DEFINITION OF RETAIL EXPOSURES .. 55II. RANGE OF FAMILIES OF INPUTS: PD/LGD, OR ESTIMATES approach TO WEIGHTS FOR RETAIL EXPOSURES .. FRAMEWORK FOR THE CALIBRATION OF RISK 60 Superseded document (i)Introduction .. 60(ii)Industry survey 60(iii) Qualitative results .. 60(iv) Quantitative RISK WEIGHTS FOR RETAIL OF EL INPUTS INTO RISK REQUIREMENTS FOR RETAIL PORTFOLIOS .. 67(i)Introduction .. 67(ii)Proposed minimum requirements for risk segmentation .. 68D. REQUIREMENTS FOR ESTIMATION OF RISK EXPOSURES: KEY ISSUES WHERE FEEDBACK IS SOUGHT.

5 OF RETAIL OF RISK 72 CHAPTER 4: IRB approach TO BANK OF BANK OF OF DEFAULT (PD) .. GIVEN DEFAULT (LGD) .. WEIGHTS FOR BANK EXPOSURES .. REQUIREMENTS FOR BANK EXPOSURES .. 74 CHAPTER 5: IRB approach TO SOVEREIGN OF SOVEREIGN EXPOSURES .. 75II. RANGE OF 75A. PROBABILITY OF DEFAULT (PD) .. GIVEN DEFAULT (LGD) .. OF RISK REQUIREMENTS FOR SOVEREIGN EXPOSURES .. OF GRADE OVER RATING SYSTEM AND FOR USE OF OWN ESTIMATES OF LGD UNDER THE ADVANCED 77 Superseded documentCHAPTER 6: KEY ISSUES IN DEVELOPING AN approach TO EQUITYEXPOSURES FOR IRB OF APPROACHES .. ratings 80(i)Pros of a corporate debt framework for equity .. 81(ii)Cons of a corporate debt framework for equity .. MARKET RISK OR STRESS TEST approach TO EQUITY 82(i)Pros of a market risk/stress test approach .

6 82(ii)Cons of a market risk/stress test approach .. EXPOSURES: KEY ISSUES WHERE FEEDBACK IS 82 CHAPTER 7: KEY ISSUES IN DEVELOPING AN IRB approach TO PROJECT OF OF PROJECT FINANCE IN MEASUREMENT OF PD, LGD, AND EAD, AND ASSOCIATED DATA HIGHER CORRELATIONS AMONG PD, LGD, AND INPUTS INTO AN IRB FRAMEWORK FOR PROJECT FINANCE .. 1: SEPARATE ANALYSES OF PD, LGD, AND 2: SEPARATE ANALYSES OF EL AND 3: PROVIDE FOR BOTH OPTIONS 1 AND 2 .. OF FURTHER RELATED TO A RISK WEIGHT THOUGHTS ON MINIMUM REQUIREMENTS .. FINANCE: KEY AREAS WHERE FEEDBACK IS SOUGHT .. 88 CHAPTER 8: OF THE GRANULARITY ADJUSTMENT .. BACKGROUND .. OF APPLICATION .. FOR THE GRANULARITY ADJUSTMENT .. AGGREGATION AND CREDIT RISK MITIGATION .. 93VI. TECHNICAL DERIVATION .. 93 CHAPTER 9: IMPLEMENTATION TRANSITIONAL ARRANGEMENTS.

7 OF THE IRB approach ACROSS ALL 101 III. ADOPTION OF ELEMENTS OF THE ADVANCED approach FOR 102 Superseded documentSuperseded document1 The internal ratings - based ApproachChapter 1: Overview and Orientation of IRB ApproachI. Introduction1. In this section of the consultative package, the Committee sets out its proposals foran internal ratings based approach (the IRB approach ) to capital requirements for credit Committee believes that such an approach , which relies heavily upon a bank s internalassessment of its counterparties and exposures, can secure two key objectives consistentwith those which support the wider review of The New Basel Capital Accord. The first isadditional risk sensitivity, in that a capital requirement based on internal ratings can prove tobe more sensitive to the drivers of credit risk and economic loss in a bank s portfolio.

8 Thesecond is incentive compatibility, in that an appropriately structured IRB approach canprovide a framework which encourages banks to continue to improve their internal riskmanagement practices. In meeting these objectives, the Committee is mindful that the IRBapproach should continue to promote and enhance competitive equality across Committee is also mindful to ensure that the IRB approach should continue to promotesafety and soundness in the financial system and, consistent with providing incentivecompatibility, that the structure and requirements of the IRB approach do not impinge uponor undermine banks well-established lending and credit risk management The idea of an IRB approach to capital requirements was discussed briefly in thefirst consultative Paper issued in June 1999.

9 The Committee has undertaken significant worksince that time to develop its proposals. An integral part of this work has been consultationwith industry associations and individual banks in the form of surveys, requests for data andpresentations. Feedback from these efforts has helped shape the proposals, and theCommittee wishes to express its gratitude to those who participated in these In taking forward this work on an IRB approach , the Committee has sought todevelop a framework which is credible, is prudentially sound and that reflects sound creditrisk management practices in the industry. In addition to providing incentives for individualbanks, the Committee hopes that, at the same time, the approach will accommodate andprovide incentives for the ongoing improvement in risk management practices at anindustry-wide The Committee believes that the best way of securing these objectives is throughthe adoption of an evolutionary approach to the IRB framework, which mirrors the ongoingevolution of credit risk management itself.

10 Banks have made use of internal rating systemsfor a very long time as a means of categorising their exposures into broad, qualitativelydifferentiated layers of risk. Many banks have in recent years made considerable progress inenhancing these traditional, qualitatively-oriented internal assessments of credit risk byexpanding their capabilities for quantifying the credit risk associated with their Building upon that capability, for each exposure class ( corporate, retail,sovereign), the IRB approach will provide for a single framework by which a given set of riskcomponents or inputs are translated into minimum capital requirements. However, inrespect of some of these risk components, two methodologies for the estimation arepresented. In its surveys of bank practice and discussions with the industry, the Committeehas discovered that many banks, including some best-practice banks, currently facedifficulties in establishing credible and reliable estimates of some risk factors, which can beSuperseded document2adequately validated by both the bank and its supervisor.