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

Foundation
Foundation Internal
Internal
Ratings
Ratings
Based
Based Approach
Approach

Standardized
Standardized
Approach
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

INCREASED SOPHISTICATION

Advanced
Advanced Internal
Internal
Ratings
Ratings Based
Based
Approach
Approach

Banks use internal

estimations of PD, loss
given default (LGD) and
exposure at default
(EAD) to calculate risk
weights for exposure
classes

RWA for Corporate Exposures

Standardized Approach
Large Corporate Exposures (>Rs. 5 Crore)
Adjusted
Exposure
RWA
External
Exposure
Exposure
(Rs.
(Rs.
Ratings
(Rs. Crore)
(%)
Crore)
RW
Crore)
AAA
3000.0
4.8%
1030.0
20%
206.0
AA
6000.0
9.7%
3900.0
30%
1170.0
A
6500.0
10.5%
5064.0
50%
2532.0
BBB
15000.0
24.2%
11569.0
100% 11569.0
BB & Below
6500.0
10.5%
5308.0
150%
7962.0
Unrated
25000.0
40.3%
16796.0
100% 16796.0
Performing
Assets Total
62000.0
100.0%

D < 20%
provision
40.0
20.0
150%
30.00
D < 50%
provision
74.0
44.4
100%
44.40
D > 50%
provision
196.0
147.0
50%
73.50
NPA Total
310.0

Credit RWA Total 40382.90

Credit Risk Capital Required (Min. 9%) 3634.46

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 banks 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 riskweighted 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 () 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 Internal
ratingRating
wise and pooled PD
Category
AAA
AA
A
BBB
BB
B
C

PD Estimate Risk Weight

0.03%
14.44%
0.15%
37.42%
0.51%
70.24%
1.10%
95.47%
2.19%
117.79%
5.00%
149.85%
10.00%

193.09%

RWA for Corporate Exposures IRB

Approach
Large Corporate Exposures (>Rs. 5 Crore)
Net
EAD (Rs.
Exposure
RWA (Rs.
Internal Ratings
Crore)
EAD (%)
(Rs. Crore)
RW
Crore)
AAA
12000.0
1.9%
13%
1540.6
AA
16000.0
2.6%
33%
5322.5
A
14500.0
2.3%
62%
9053.0
BBB
13000.0
2.1%
85%
11031.7
BB
4500.0
0.7%
105%
4711.7
B
1500.0
0.2%
133%
1998.1
C
500.0
0.1%
172%
858.2
Unrated
0.0
0.0%
100%
0.0
Performing
Assets Total
62000.0
10.0%

D < 20%
provision
40.0
36.0
150%
54.00
D < 50%
provision
74.0
44.4
100%
44.40
D > 50%
provision
196.0
49.0
50%
24.50
NPA Total
310.0

Credit RWA Total 34638.63

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)

676.79

Capital Savings Compared to Standardized Approach

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 (PD*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 banks 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
Adjusted
Shocked
Gross
Gross
Exposur
RWA
Adjusted RWA
External
Exposure Exposur e (Rs.
(Rs.
Exposure (Rs.
Ratings
(Rs. Crore) e (%)
Crore)
RW
Crore) (Rs. 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
40382.9
40755.5
Credit RWA Total
0
1
Credit Risk Capital Required (Min. 9%)
3634.46
3668.00
Additional Capital Required for Stress Scenarios

33.53

ICAAP Impact on Credit Risk

Capital

Large Corporate Exposures (>Rs. 5 Crore)

Stressed Scenario
Net
Exposur
Internal
EAD (Rs.
e (Rs.
RWA (Rs.
Shocked RWA (Rs.
Ratings
Crore) EAD (%) Crore)
RW
Crore)
RW
Crore)
AAA
12000.0
1.9%
13%
1540.6 15.27% 1832.6
AA
16000.0
2.6%
33%
5322.5 36.83% 5892.3
A
14500.0
2.3%
62%
9053.0 69.39% 10061.9
BBB
13000.0
2.1%
85%
11031.7 92.89% 12075.1
BB
4500.0
0.7%
105%
4711.7 114.17% 5137.5
B
1500.0
0.2%
133%
1998.1 150.10% 2251.5
C
500.0
0.1%
172%
858.2 188.27%
941.3
Unrated
0.0
0.0%
100%
0.0
100%
0.0
Performing
Assets Total
62000.0 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
196.0
49.0
50%
24.50
24.9
NPA Total
310.0

38317.2
Credit RWA Total
34638.63
9
Credit Risk Capital Required (Min. 9%)
3117.48
3448.56

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