Page 40 - Banking Finance May 2021

ARTICLE

RBI, to use their own internal estimates Y Corporate
for some or all of the credit risk Y Sovereign
components Probability of Default
Y Bank
(PD), Loss Given Default (LGD),
Exposure at Default (EAD) and Y Retail
Effective Maturity (M)] in determining Y Equity
the capital requirement for given
Y Others
credit exposure.
The IRB approach allows it to use Key Concepts in IRB Approach
internal models to calculate credit 1. Probabily of Default (PD)
capital, enabling more sensitivity to the
It is the probability that a borrower with certain credit rating will fail to pay the
credit risk in the bank's portfolio.
interest or repayment obligation on the due date. It aims to measure the
Furthermore, incorporating better risk
probability of borrower assigned with a rating other than default rate defaulting
management techniques on its over a specific time horizon. Banks which have an internal rating methodology
portfolio will show its effect on
use the same to differentiate the corporate borrowers into different rating
minimizing the regulatory capital
grades corresponding to varying credit risk profile. The borrowers in different
required. Another incentive to move to rating grades will have different likelihood of default.
the IRB approach is that the IRB-based
regulatory capital is "lower than" the
Bank would need to compute its internal rating wise PD for the corporate
standardized approach for higher
portfolio. PD may be estimated based on the historical default data.
credit-rated banks and "higher than"
for lower credit-rated banks, thus
EXAMPLE: From the above-mentioned table if we try to see the no of accounts
providing a better alternative for
in the rating grade UBC 4 was 200 at the beginning of the year and at the end,
investment-grade banks.
5 accounts migrated to default so the PD works out to be 2.5%.
The IRB approach is again The PD estimate arrived using the above method is used for 12 months ECL

classified into: computation. For lifetime ECL, LIFE Time PD is required to be estimated from 12
a) Foundation IRB (FIRB) approach: months PD using matrix multiplication method.
Banks estimate Probability of
Default (PD) using internal models, TOTAL
while the other parameters take NO AT
supervisory estimates. THE
RATING BEGNING PD
b) Advanced IRB (AIRB) approach:
GRADES OF YEAR MIGRATION DURING THE YEAR IN %
Banks provide their own estimate
of PD, Loss Given Default LGD, and UBC4 UBC5 UBC6 UBC7 UBC8 UBC9 DEFAULT
Exposure at default (EAD) and UBC4 200 180 10 5 5 2.5
their calculation for Maturity (M)
is subject to the supervisory UBC5 250 200 20 10 10 10 5
requirements. UBC6 150 100 40 10 6.66

UBC7 50 30 10 10 20
Under the IRB approach, banks are
required to categorize their banking UBC8 20 20 10 50
book exposures into the following asset
classes: LGD = 1 - Recovery Rate

40 | 2021 | MAY | BANKING FINANCE