Internal‐Ratings‐Based Approach

Abstract Within the new Basel capital rules for banks (Basel II), the internal‐ratings‐based approach (IRBA) represents perhaps the most important innovation for regulatory minimum capital requirements. For the first time, subject to supervisory approval, banks are allowed to use their own risk assessments of credit exposures in order to determine the capital to be held against them. Within the IRBA, banks estimate the riskiness of each exposure on a stand‐alone basis. The risk estimates serve as input for a supervisory credit risk model (implicitly given by risk weight functions) that provides a value for capital that is deemed sufficient to cover against the credit risk of the exposure, given the assumed portfolio diversification. In order to obtain supervisory approval for the IRBA, banks must apply for IRBA and fulfill a set of minimum requirements aimed at ensuring the integrity of the rating model, rating process, and thus of the risk parameters and capital charges. Although risk quantification via IRBA can be of great use for the bank internal credit risk measurement and management, there are some limitations. The most important of these is surely that the IRBA provides no measure of risk concentrations. If banks are concerned about concentration effects or want to measure the diversification benefits of their portfolio, they need to develop their own, full‐fledged credit risk models.