Advanced Internal Ratings Based Credit Risk

Basel Asset Class

For the purpose of deriving the Regulatory Capital requirement under an IRB approach, an ADI must assign its banking book exposures to one of the following IRB asset classes:

• corporate (which includes the four sub-asset classes of specialised lending);
• sovereign;
• financial institution; and
• retail (which consists of four separate sub-asset classes).

Probability of Default

Probability of Default (PD) – means the risk of borrower defaulting (being more than 90 days past due or declared unlikely to pay) within the next 12 months. The probability of default can be determined through a range of techniques from judgmental to actuarial/statistical. Both processes are often benchmarked to the rating scales of Credit Rating Agencies such as Standard and Poors (S&P), Moodys and Fitch. These agencies maintain databases of historical defaults and default rates by relative risk grades. Based on that data and using the S&P scale the best (AAA) rated credits on 35 in 1,000,000 have defaulted annually, while 9 in 10 of the worst rated credits (C) have defaulted annually. The following page compares a range of retail and wholesale rating scales in common use and their long run calibration.

For risk grading purposes probabilities of default vary significantly with the business cycle, increasing substantially in economic downturns when many firms default together. The PD used for Risk Weight calculation purposes should be a through the cycle or long run PD. This requires averaging out the business cycle influences and ensuring, in good economic conditions, that the default probability is not understated due to over-valued assets or short-term bonus income.

Loss Given Default

Loss Given Default (LGD) – means the ADI’s net economic loss on the default of a borrower. Economic losses in default arise due to payment shortfalls, administration costs, enforcement costs but are offset by collateral recoveries and insurance payouts. The net economic loss requires considering the timing and the losses and recoveries relative to the returns which would be generated in alternative non-default scenarios.

Different industries, assets, facilities and regions may experience different economic loss outcomes due to structural features of markets and lending contracts and these should be reflect in the long run average loss outcomes.

Downturn Loss Given Default

An ADI must take into account the potential for loss to be higher than the default-weighted average during a period when credit losses are substantially higher than average. That is, LGD estimates must reflect economic downturn conditions, where necessary, to capture relevant risks.

Downturn LGD can be expressed as a function of the facility default risk and the asset correlation. That is because the economic loss on a facility is largely determined by the economic health of the borrower, rectification of missed payments is a primary outcome the likelihood of which decreases substantially in an economic downturn. The following tool follows the methodology of Frye-Jacobs to derive downturn LGDs from their long run average.

Effective Maturity

Effective maturity means the remaining effective term of a credit obligation and is calculated as the cashflow weighted term, for a simple amortising loan with equal payment installments over 10 years the effective maturity is half the contractual maturity. A longer term facility, with a higher effective maturity increases the Risk Weighted Asset requirements because of the higher potential investment risk, market value volatility of long term exposures and high outstanding credit for longer.

Turnover/Sales

Firm-size adjustment for small- and medium-sized enterprises applies where corporate counterparties form part of a group of connected borrowers that has reported consolidated annual revenue of less than $75 million, an ADI may apply an adjustment to the corporate risk-weight function by substituting the standard corporate correlation formula.