Credit Risk Capital Allocation – IRB Approach

1. Credit Risk Capital Allocation – IRB Approach TasneemChherawala NIBM

2. 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

3. REDUCED CAPITAL REQUIREMENT PILLAR 1 FOR CREDIT RISK Banks use internal estimations of PD, loss given default (LGD) and exposure at default (EAD) to calculate risk weights for exposure classes INCREASED SOPHISTICATION Advanced Internal Ratings Based Approach Foundation Internal Ratings Based Approach Banks use internal estimations of probability of default (PD) to calculate risk weights for exposure classes. Other risk components are standardized. Standardized Approach Regulatory Risk weights are based on assessment by external credit assessment institutions Credit Risk Approaches under Basel II • Three Approaches for Credit Risk Capital Charge

4. RWA for Corporate Exposures – Standardized Approach

5. 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 bank’s 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

6. 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 risk-weighted assets and therefore capital requirements. • The Risk Weighted Asset (RWA) = Risk Weight * EAD • The total Credit RWA = ∑ RWAi • Credit Risk Capital = RWA * 9%

7. IRB Approach for Credit Risk Categorisation of Exposures • Classes of Assets • Corporate • SME • Specialisedlending sub classes • Sovereign • Bank • Retail • Equity

8. 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 (ρ) 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

9. Risk Weight Function Risk Weight Function for Corporate, Bank and Sovereign Exposures excluding SL

10. 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 rating wise and pooled PD

11. RWA for Corporate Exposures – IRB Approach

12. RWA for Retail Portfolio – IRB Approach

13. 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%

14. 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 (ΣPD*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

15. 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 bank’s 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

16. ICAAP Impact on Credit Risk Capital

17. ICAAP Impact on Credit Risk Capital

18. 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

19. 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

20. 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

21. 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