Oct 04

Basel II: IRB Approach concepts

by David Harper, CFA, FRM, CIPM

FRM |

basel2PicIntro

Learning Outcomes

  • LO 68.4: Discuss the concepts of expected loss, unexpected loss calibration, and downturn loss given default that are part of the IRB approach.
  • LO 68.5: List the necessary conditions for the IRB credit risk weight function.

Here is a possible distribution of credit portfolio losses. It skews due to limited upside (best result no defaults but there is limited upside on a credit portfolio), a statistically likely concentration of a few defaults, and the remote possibility of steep losses (high frequency of defaults to devastating effect):

expectedLossCurve

Expected loss (EL) (FRM 68.4)

A credit portfolio expects defaults. Expected loss (EL) is the cost of doing business (making loans). Basel II therefore assumes EL will be covered by loan loss provisions. Similar to companies that make provisions for a percentage of receivables that will not be collected, a bank creates provisions (contra-asset accounts) for anticipated defaults. The provision is the accounting entry. When a write-off actually occurs, it is charged against the provision.

Of course, these expected losses are reflected in the interest rates they charge (i.e., higher margins).

Unexpected loss calibration (UL) (FRM 68.4)

To remind where we are, this now refers to either the Foundation or Advanced internal-ratings based (IRB) approach to estimating credit risk under Basel II.

Basel II wants bank capital to cover the entire amount (distance) from the origin above to the value-at-risk (VaR). In other words, they want banks to have a cushion against EL + UL = VaR. So, there is a test for coverage of the EL with reserves. If the bank is "whole" on coverage of the EL, then the Basel capital charge "fills the VaR gap:" it charges for unexpected loss (UL) segment.

Downturn loss given default (Downturn LGD) (FRM 68.4)

But Basel wants to be conservative about the estimate. So, the average loss given default (LGD) is transformed into a downturn LGD, which is an LGD that:

"reflects economic-downturn conditions in circumstances where loss severities are expected to be higher during cyclical downturns than during typical business conditions."

Requirements for the IRB credit risk weight function (FRM 68.5)

Here are the requirements:

  • Portfolios are diversified: they are composed of diverse exposure (note: this and the next assumption, portfolio invariance, are hugely simplifying - they are done out of necessary convenience but they create such a model risk that the entire approach can be disputed)
  • Risk-weights are portfolio invariant: i.e., the calculation of risk is independent of the portfolio. Any correlation with other assets in the portfolio is not explicitly included in risk estimation.
  • Expected losses are covered by provisions or revenue (note: as above, the method assumes EL are appropriately covered by the bank)
  • Unexpected losses are covered by bank capital
  • Unexpected losses will exceed capital at a small pre-determined acceptable probability. This probability is called the confidence level
  • All systematic risks are modeled by a single risk factor. Unsystematic, or idiosyncratic risks, are assumed to converge to zero (i.e., diversification will net them out

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