How banks measure credit risk?

Credit risk measurement: Credit risk arises when a bank borrower or counter- party fails to meet his obligations according to specified schedule in terms of predetermined agreement either due to genuine problems or willful default. Banks are using two broad methodologies for computing their capital requirements for credit risk as per Basel II guidelines. First method is standardized approach and second method is Internal Rating Based approach.

Standardised approach (SA): The term standardized approach (or standardised approach) refers to a set of credit risk measurement techniques proposed under Basel II capital adequacy rules for banking institutions. Under the SA, the banks use a risk-weighting schedule for measuring the credit risk of its assets by assigning risk weights based on the rating assigned by the external credit rating agencies.

Internal rating based approach (IRB) – Under this approach, banks are allowed to use their own estimated internal risk parameters calculating counterparties and exposures for the purpose of regulatory capital. Under IRB Approach, the accord has made available two broad approaches viz. foundation approach and advanced approach.

Under foundation approach or Foundation IRB (F-IRB), as a general rule, banks provide their own estimates of PD (Probability of default) and rely on supervisory estimates for other risk components. However, foundation approach is not available for retail exposures. For retail exposures banks are required to use their own estimates of the IRB parameters (Probability of default (PD), Loss Given Default (LGD), Credit conversion factors (CCF) subject to approval of the banking regulator. Then total required capital is calculated as a fixed percentage of the estimated RWA.

Under the advanced approach or Advanced IRB (A-IRB), banks provide for more of their own estimates of PD, LGD and EAD (exposure at default) and their own calculation of M, subject to meeting minimum standards approved by local regulator. Then total required capital is calculated as a fixed percentage of the estimated RWA.  The IRB approach allows a finer differentiation of risk for various exposures and hence delivers capital requirements that are better aligned to the degree of risks.