Internal rating based approach:

One of the approaches under Basel II for the calculation of minimum

capital requirements for credit risk. Under this approach, banks will be

able to rely on their own internal rating systems for assessments of credit

risk in order to calculate the capital which they must hold, provided that

they can satisfy their supervisors that their systems meet a set of

minimum supervisory standards.

There are two types of internal rating based approach:

1. Foundation

2. Advanced

Foundation:

The IRB Foundation Approach is the basic method by which a Bank may

use its Internal Ratings as the basis for calculating Regulatory Capital.

The key principle of the Approach is that a Bank must maintain an Internal

Rating system and use it to grade each obligor (or group of obligors) by

the Probability of Default. Firms will use a number of Risk Grading systems

for different types of obligor. Extent and nature of the firms Credit Risk

and provide details of credit risk processes.

Advanced :

Although many firms will commence Basel II by using the Foundation

approach many intend to move to the advanced approach therefore data

to satisfy both approaches has to be defined.

Basel stipulates additional Public Disclosure reporting that define the

extent and nature of the firms Credit Risk and provide details of the firm’s

credit risk processes. The IRB Advanced Approach is a significantly refined

approach to calculating Credit Risks. The key refinements to the

Foundation Approach calculation are:

A firm will use its own internal estimates of EAD (Exposure at Default) and

LGD (Loss given Default) together with the treatment of Guarantees and

Credit Derivatives, rather than the parameterized method under the

Foundation approach; Effective Maturity is used in addition to EAD, PD

(Probability of default), and LGD in calculating Regulatory Capital (in order

to more accurately reflect the impact of transaction maturity on default

risk). Historic data will be maintained and compared to actual EAD, LGD

etc in order to validate and refine the calculations. Firms usually will

intend to use the Advanced Approach for Corporate exposures as soon as

possible after the Basel II Implementation date (and may decide to use the

Advanced approach immediately for Specialized Lending).As a result, data

will be calculated and captured using both the Foundation and Advanced

Approach for each exposure. Although the inputs to the Advanced

Approach differ from the Foundation Approach, the same models for GAE,

EAD, PD and LGD will commonly be used.