# Internal ratings-based approach (credit risk) Canonical: https://web4.xpay.bi/en/wiki/wp-en-32944408/ Language: en Published: 2026-10-26T16:33:26.183Z Updated: 2026-10-26T16:33:26.183Z 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 ## Key facts ## Overview 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. Reforms to the internal ratings-based approach to credit risk are due to be introduced under the Basel III: Finalising post-crisis reforms standards. ## Overview 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 - Risk sensitivity - Capital requirements based on internal estimates are more sensitive to the credit risk in the bank's portfolio of assets Incentive compatibility - Banks must adopt better risk management techniques to control the credit risk in their portfolio to minimize regulatory capital To use this approach, a bank must take two major steps: Categorize their exposures into various asset classes as defined by the Basel II accord Estimate the risk parameters—probability of default (PD), loss given default (LGD), exposure at default (EAD), maturity (M)—that are inputs to risk-weight functions designed for each asset class to arrive at the total risk weighted assets (RWA) The regulatory capital for credit risk is then calculated as 8% of the total RWA under Basel II. ## Categorization of exposures Each banking exposure is categorized into one of these broad asset classes: Corporate Sovereign Bank Retail Equity 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. ## Corporate 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 - Project Finance - financing industrial projects based upon the projected cash flows of the particular project Object Finance - financing physical assets based upon the projected cash flows obtained primarily through the rental or lease of the particular assets Commodities Finance - financing the reserves, receivables or inventories of exchange-traded commodities where the exposure is paid back based on the sale of the commodity rather than by the borrower from independent funds Income-producing real estate - financing real estate that is usually rented or leased out by the debtor to generate cash flow to repay the exposure High-volatility commercial real estate - financing commercial real estate, which demonstrate a much higher volatility of loss rates as compared to other forms of specialized lending ## Sovereign 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. ## Bank 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. ## Retail Loans made to individuals fall under this category. Credit cards, overdrafts or residential mortgages are some of the common retail lending products treated as part of this category in the IRB approach. Subject to a maximum of 1 million euros, exposures to small businesses managed as retail exposures also fall under this category. Retail exposures are usually not managed by the bank on an individual basis for risk rating purposes, but as groups of exposures with similar risk characteristics. The sub-classes of exposures falling into this category are - Residential mortgage Qualifying revolving exposure (QREs) - unsecured revolving exposures where the undrawn portion of the exposure is unconditionally cancellable by the bank Other retail ## Equity Direct ownership interests in the assets and income of a financial institution, or indirect interests through for example derivatives come under this category. For an exposure to qualify under this category, the return of the funds invested on the equities can be only realized through their sale or by liquidation of the issuer of these equities. ## Foundation and advanced approaches To calculate capital requirements for all banking exposures, there are three main elements Risk parameters - Probability of default (PD), Exposure at default (EAD), Loss Given Default (LGD), Maturity (M) Risk-weight functions - Functions provided as part of the Basel II regulatory framework, which maps the risk parameters above to risk-weighted assets Minimum requirements - Core minimum standards that a bank must satisfy to use the internal ratings-based approach The accord provides two broad approaches that a bank can follow: Foundation approach In this approach, banks calculate their own PD parameter while the other risk parameters are provided by the bank's national supervisor Advanced approach In this approach, banks calculate their own risk parameters subject to meeting some minimum guidelines. However, the foundation approach is not available for Retail exposures. For equity exposures, calculation of risk-weighted assets not held in the trading book can be calculated using two different ways: a PD/LGD approach or a market-based approach. ## Minimum requirements To adopt the IRB approach and its continued use, a bank must satisfy certain minimum requirements that it can demonstrate to the national supervisor. They are described in the following twelve sub-sections. ## Composition The minimum requirements state that estimates of risk parameters must Reflect borrower and transaction characteristics Provide for meaningful differentiation of risk Be accurate and consistent in the estimation of risk The risk parameters must also be consistent with their use in making risk management decisions. The minimum requirements apply to all asset classes. ## Compliance To adopt the IRB approach, a bank must demonstrate ongoing compliance with the minimum requirements. If a bank does not satisfy the minimum requirements at any point of time, they must submit to the supervisor a plan outlining how they intend to return to compliance along with definite timelines. Supervisors may take appropriate action or require the banks to hold additional capital in case of non-compliance. ## Sources - Internal ratings-based approach (credit risk) · Wikipedia: https://en.wikipedia.org/?curid=32944408 Source: Wikipedia contributors — https://en.wikipedia.org/?curid=32944408&oldid=1380871694 Licence: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation notice: Reformatted for XPay; the source may be abridged, restructured or translated. Consult the cited revision for the original.