Basel Committee
`on Banking Supervision
`
`Consultative Document
`The Internal
`Ratings-Based Approach
`
`Supporting Document
`to the New Basel Capital Accord
`
`Issued for comment by 31 May 2001
`
`January 2001
`
`Superseded document
`
`GAIN CAPITAL - EXHIBIT 1018
`
`

`

`Table of Contents
`
`CHAPTER 1: OVERVIEW AND ORIENTATION OF IRB APPROACH.................................................1
`
`I.
`
`II.
`
`INTRODUCTION ........................................................................................................................1
`
`ORIENTATION OF THE IRB APPROACH................................................................................3
`
`III.
`
`A.
`B.
`
`SIMPLE SCHEMATIC OF IRB APPROACH .............................................................................4
`CATEGORISATION OF EXPOSURES.................................................................................................. 5
`RISK COMPONENTS ....................................................................................................................... 5
`Probability of Default .............................................................................................................. 6
`(i)
`Loss Given Default ................................................................................................................. 6
`(ii)
`(iii) Exposure at Default (EAD) ..................................................................................................... 6
`(iv) Maturity................................................................................................................................... 7
`C. RISK WEIGHTS .............................................................................................................................. 7
`D. MINIMUM REQUIREMENTS .............................................................................................................. 7
`(i)
`Adherence to minimum requirements .................................................................................... 7
`CHAPTER 2: IRB FRAMEWORK FOR CORPORATE EXPOSURES...................................................9
`
`DEFINITION OF CORPORATE EXPOSURES..........................................................................9
`
`I.
`
`II.
`
`III.
`
`IV.
`A.
`
`RANGE OF PRACTICE..............................................................................................................9
`THE NUMBER OF GRADES BOTH FOR PERFORMING AND NON-PERFORMING LOANS............................. 9
`A.
`THE DECISION WHETHER TO FOCUS THE RATING ON THE BORROWER OR THE FACILITY .................... 10
`B.
`THE MEANS BY WHICH RATINGS ARE ASSIGNED ............................................................................. 10
`C.
`D. THE RISK FACTORS CONSIDERED IN THE RATING ASSIGNMENT PROCESS ........................................ 11
`E. THE TIME HORIZON OVER WHICH THE RATING IS CONSIDERED A VALID RISK INDICATOR .................... 12
`F. USE OF INTERNAL RATINGS.......................................................................................................... 12
`RISK COMPONENTS...............................................................................................................13
`A. OVERVIEW .................................................................................................................................. 13
`PROBABILITY OF DEFAULT (PD) ................................................................................................... 15
`B.
`Average PD per grade.......................................................................................................... 15
`(i)
`(ii) One year PD......................................................................................................................... 16
`(iii) Methods for quantifying PD .................................................................................................. 16
`(iv)
`Impact of credit derivatives and guarantees on estimation of PD........................................ 16
`LOSS GIVEN DEFAULT (LGD) ...................................................................................................... 18
`Foundation approach............................................................................................................ 19
`LGD under the advanced approach ..................................................................................... 21
`EXPOSURE AT DEFAULT .............................................................................................................. 22
`Transactions with uncertain future drawdown...................................................................... 23
`(i)
`(ii) OTC derivatives.................................................................................................................... 24
`E. MATURITY................................................................................................................................... 25
`(i)
`Introduction........................................................................................................................... 25
`(ii)
`Treatment of maturity under the foundation IRB approach .................................................. 26
`(iii) Treatment of maturity under the advanced IRB approach ................................................... 27
`(iv) Definition of ‘effective maturity’............................................................................................. 27
`(v)
`Information required by banks.............................................................................................. 28
`F. DISCUSSION ON DEFINITION OF DEFAULT ......................................................................................... 29
`(i)
`Current practice for corporate exposures............................................................................. 29
`(ii) Reference definition of default.............................................................................................. 30
`(iii) Prospects of a “mapping” for estimates based on other definitions ..................................... 31
`RISK WEIGHTS FOR CORPORATE EXPOSURES ...............................................................31
`DETERMINATION OF RISK WEIGHTED ASSETS ................................................................................ 31
`
`C.
`
`D.
`
`(i)
`(ii)
`
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`V.
`
`E.
`
`A.
`B.
`
`FORMULA FOR RWA FOR CORPORATE EXPOSURES ...................................................................... 32
`B.
`C. CALIBRATION OF BENCHMARK RISK WEIGHTS FOR CORPORATE EXPOSURES ................................... 33
`(i)
`Introduction........................................................................................................................... 34
`(ii) Survey-based evidence........................................................................................................ 35
`(iii) Direct estimates of risk weights............................................................................................ 35
`D. MATURITY-ADJUSTMENTS TO CORPORATE RISK WEIGHTS .............................................................. 36
`(i) Maturity-adjustments based on MTM approach................................................................... 37
`(ii) Maturity-adjustments based on adjusted DM approach....................................................... 38
`EXPECTED LOSS AND THE DETERMINATION OF CORPORATE RISK WEIGHTS ..................................... 40
`MINIMUM REQUIREMENTS FOR CORPORATE EXPOSURES UNDER THE FOUNDATION
`APPROACH ...................................................................................................................41
`INTRODUCTION............................................................................................................................ 41
`CRITERIA TO ENSURE MEANINGFUL DIFFERENTIATION OF RISK ....................................................... 42
`(i) Overall rating system structure.............................................................................................42
`(ii) Rating grade structure.......................................................................................................... 43
`C. COMPLETENESS AND INTEGRITY OF RATING ASSIGNMENTS ............................................................ 43
`(i)
`Introduction........................................................................................................................... 43
`(ii) Coverage of ratings .............................................................................................................. 43
`(iii)
`Independent assignment or review ...................................................................................... 44
`D. OVERSIGHT OVER THE RATING SYSTEM AND PROCESSES............................................................... 44
`(i)
`Introduction........................................................................................................................... 44
`CRITERIA AND ORIENTATION OF RATING SYSTEM ........................................................................... 45
`Introduction........................................................................................................................... 45
`(i)
`(ii) Assessment horizon ............................................................................................................. 45
`F. MINIMUM REQUIREMENTS FOR ESTIMATION OF PD ........................................................................ 46
`G. DATA COLLECTION AND IT SYSTEMS............................................................................................. 48
`H. USE OF INTERNAL RATINGS.......................................................................................................... 48
`INTERNAL VALIDATION.................................................................................................................. 49
`I.
`DISCLOSURE OF KEY INTERNAL RATINGS INFORMATION ................................................................. 49
`J.
`USE OF SUPERVISORY ESTIMATES OF EAD, LGD, AND GUARANTEES/CREDIT DERIVATIVES............. 49
`K.
`Requirements for LGD.......................................................................................................... 49
`(i)
`(ii) Standards for supervisory estimates of EAD........................................................................ 50
`(iii) Standards for supervisory treatment of guarantees/credit derivatives................................. 50
`MINIMUM REQUIREMENTS FOR THE ADVANCED APPROACH TO CORPORATE
`EXPOSURES..................................................................................................................50
`REQUIREMENT FOR LOSS GIVEN DEFAULT ................................................................................... 50
`A.
`REQUIREMENTS FOR EXPOSURE AT DEFAULT............................................................................... 51
`B.
`C. REQUIREMENTS FOR GUARANTEES AND CREDIT DERIVATIVES ........................................................ 51
`VII.
`CORPORATE EXPOSURES: KEY ISSUES WHERE FEEDBACK IS SOUGHT...................52
`A. MATURITY................................................................................................................................... 52
`REFERENCE DEFINITION OF DEFAULT............................................................................................ 53
`B.
`C. CALIBRATION OF CORPORATE RISK WEIGHTS ................................................................................ 53
`D. MINIMUM REQUIREMENTS ............................................................................................................ 54
`CHAPTER 3: IRB FRAMEWORK FOR RETAIL EXPOSURES...........................................................55
`
`E.
`
`VI.
`
`I.
`
`II.
`
`DEFINITION OF RETAIL EXPOSURES..................................................................................55
`
`RANGE OF PRACTICE............................................................................................................56
`
`III.
`
`RISK COMPONENTS...............................................................................................................57
`TWO FAMILIES OF INPUTS: PD/LGD, OR EL.................................................................................. 57
`A.
`B. OWN ESTIMATES APPROACH TO INPUTS........................................................................................ 58
`IV.
`RISK WEIGHTS FOR RETAIL EXPOSURES .........................................................................59
`A.
`INTRODUCTION............................................................................................................................ 59
`CONCEPTUAL FRAMEWORK FOR THE CALIBRATION OF RISK WEIGHTS ............................................. 60
`B.
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`V.
`
`Introduction........................................................................................................................... 60
`(i)
`Industry survey results.......................................................................................................... 60
`(ii)
`(iii) Qualitative results ................................................................................................................. 60
`(iv) Quantitative results............................................................................................................... 62
`BENCHMARK RISK WEIGHTS FOR RETAIL EXPOSURES .................................................................... 62
`C.
`TRANSLATION OF EL INPUTS INTO RISK WEIGHTS .......................................................................... 65
`D.
`E. MATURITY................................................................................................................................... 66
`MINIMUM REQUIREMENTS FOR RETAIL PORTFOLIOS ....................................................66
`INTRODUCTION............................................................................................................................ 66
`RATING STRUCTURE.................................................................................................................... 67
`SEGMENTATION .......................................................................................................................... 67
`Introduction........................................................................................................................... 67
`(i)
`(ii) Proposed minimum requirements for risk segmentation...................................................... 68
`D. REQUIREMENTS FOR ESTIMATION OF RISK COMPONENTS............................................................... 70
`VI.
`RETAIL EXPOSURES: KEY ISSUES WHERE FEEDBACK IS SOUGHT .............................71
`A.
`DEFINITION OF RETAIL EXPOSURES............................................................................................... 71
`DERIVATION OF RISK WEIGHTS ..................................................................................................... 71
`B.
`C. MINIMUM REQUIREMENTS ............................................................................................................ 72
`CHAPTER 4: IRB APPROACH TO BANK EXPOSURES....................................................................73
`
`A.
`B.
`C.
`
`I.
`
`II.
`
`DEFINITION OF BANK EXPOSURES.....................................................................................73
`
`RANGE OF PRACTICE............................................................................................................73
`
`III.
`
`RISK COMPONENTS...............................................................................................................73
`PROBABILITY OF DEFAULT (PD) ................................................................................................... 73
`A.
`LOSS GIVEN DEFAULT (LGD) ...................................................................................................... 73
`B.
`C. MATURITY................................................................................................................................... 73
`EXPOSURE MEASUREMENT .......................................................................................................... 74
`D.
`IV.
`RISK WEIGHTS FOR BANK EXPOSURES............................................................................74
`
`V.
`
`MINIMUM REQUIREMENTS FOR BANK EXPOSURES ........................................................74
`RATING CRITERIA ........................................................................................................................ 74
`A.
`CHAPTER 5: IRB APPROACH TO SOVEREIGN EXPOSURES.........................................................75
`
`I.
`
`II.
`
`DEFINITION OF SOVEREIGN EXPOSURES .........................................................................75
`
`RANGE OF PRACTICE............................................................................................................75
`
`III.
`
`RISK COMPONENTS...............................................................................................................75
`A. PROBABILITY OF DEFAULT (PD) ................................................................................................... 76
`LOSS GIVEN DEFAULT (LGD) ...................................................................................................... 76
`B.
`C. MATURITY................................................................................................................................... 76
`EXPOSURE MEASUREMENT .......................................................................................................... 76
`D.
`IV.
`CALIBRATION OF RISK WEIGHTS........................................................................................76
`
`V.
`
`MINIMUM REQUIREMENTS FOR SOVEREIGN EXPOSURES.............................................76
`DEFINITION OF DEFAULT .............................................................................................................. 76
`A.
`RATING GRADE STRUCTURE......................................................................................................... 77
`B.
`C. RATING CRITERIA ........................................................................................................................ 77
`D. OVERSIGHT OVER RATING SYSTEM AND PROCESS ......................................................................... 77
`REQUIREMENTS FOR USE OF OWN ESTIMATES OF LGD UNDER THE ADVANCED APPROACH.............. 77
`E.
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`CHAPTER 6: KEY ISSUES IN DEVELOPING AN APPROACH TO EQUITY
`EXPOSURES FOR IRB BANKS....................................................................................79
`
`I.
`
`II.
`
`III.
`
`OVERVIEW...............................................................................................................................79
`
`A.
`
`B.
`
`DISCUSSION OF APPROACHES...........................................................................................80
`INTERNAL RATINGS FRAMEWORK.................................................................................................. 80
`Pros of a corporate debt framework for equity ..................................................................... 81
`(i)
`(ii) Cons of a corporate debt framework for equity .................................................................... 81
`A MARKET RISK OR STRESS TEST APPROACH TO EQUITY POSITIONS ............................................... 82
`Pros of a market risk/stress test approach........................................................................... 82
`(i)
`(ii) Cons of a market risk/stress test approach.......................................................................... 82
`EQUITY EXPOSURES: KEY ISSUES WHERE FEEDBACK IS SOUGHT.............................82
`
`CHAPTER 7: KEY ISSUES IN DEVELOPING AN IRB APPROACH TO PROJECT FINANCE.........84
`
`I.
`
`OVERVIEW...............................................................................................................................84
`
`II.
`
`III.
`
`A.
`B.
`C.
`
`RANGE OF PRACTICE............................................................................................................84
`DEFINITION OF PROJECT FINANCE PORTFOLIOS............................................................................. 85
`DIFFICULTIES IN MEASUREMENT OF PD, LGD, AND EAD, AND ASSOCIATED DATA LIMITATIONS ....... 85
`THE HIGHER CORRELATIONS AMONG PD, LGD, AND EAD............................................................. 85
`POTENTIAL INPUTS INTO AN IRB FRAMEWORK FOR PROJECT FINANCE...................86
`A. OPTION 1: SEPARATE ANALYSES OF PD, LGD, AND EAD.............................................................. 86
`B. OPTION 2: SEPARATE ANALYSES OF EL AND EAD......................................................................... 86
`C. OPTION 3: PROVIDE FOR BOTH OPTIONS 1 AND 2 .......................................................................... 87
`D. CONSIDERATION OF FURTHER DIMENSIONS................................................................................... 87
`IV.
`ISSUES RELATED TO A RISK WEIGHT STRUCTURE.........................................................87
`
`V.
`
`VI.
`
`PRELIMINARY THOUGHTS ON MINIMUM REQUIREMENTS..............................................88
`
`PROJECT FINANCE: KEY AREAS WHERE FEEDBACK IS SOUGHT ................................88
`
`CHAPTER 8: GRANULARITY..............................................................................................................89
`
`I.
`
`II.
`
`III.
`
`IV.
`
`V.
`
`IMPORTANCE OF THE GRANULARITY ADJUSTMENT ......................................................89
`
`CONCEPTUAL BACKGROUND .............................................................................................89
`
`SCOPE OF APPLICATION......................................................................................................90
`
`METHODOLOGY FOR THE GRANULARITY ADJUSTMENT ...............................................91
`
`EXPOSURE AGGREGATION AND CREDIT RISK MITIGATION ..........................................93
`
`VI.
`
`TECHNICAL DERIVATION......................................................................................................93
`
`CHAPTER 9: IMPLEMENTATION ISSUES........................................................................................100
`
`I.
`
`II.
`
`TRANSITIONAL ARRANGEMENTS .....................................................................................100
`
`ADOPTION OF THE IRB APPROACH ACROSS ALL EXPOSURES..................................101
`
`III.
`
`ADOPTION OF ELEMENTS OF THE ADVANCED APPROACH FOR IRB.........................102
`
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`Superseded document
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`Superseded document
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`The Internal Ratings-Based Approach
`
`Chapter 1: Overview and Orientation of IRB Approach
`
`I.
`
`Introduction
`
`In this section of the consultative package, the Committee sets out its proposals for
`1.
`an internal ratings based approach (the IRB approach) to capital requirements for credit risk.
`The Committee believes that such an approach, which relies heavily upon a bank’s internal
`assessment of its counterparties and exposures, can secure two key objectives consistent
`with those which support the wider review of The New Basel Capital Accord. The first is
`additional risk sensitivity, in that a capital requirement based on internal ratings can prove to
`be more sensitive to the drivers of credit risk and economic loss in a bank’s portfolio. The
`second is incentive compatibility, in that an appropriately structured IRB approach can
`provide a framework which encourages banks to continue to improve their internal risk
`management practices. In meeting these objectives, the Committee is mindful that the IRB
`approach should continue to promote and enhance competitive equality across countries.
`The Committee is also mindful to ensure that the IRB approach should continue to promote
`safety and soundness in the financial system and, consistent with providing incentive
`compatibility, that the structure and requirements of the IRB approach do not impinge upon
`or undermine banks’ well-established lending and credit risk management practices.
`
`The idea of an IRB approach to capital requirements was discussed briefly in the
`2.
`first Consultative Paper issued in June 1999. The Committee has undertaken significant work
`since that time to develop its proposals. An integral part of this work has been consultation
`with industry associations and individual banks in the form of surveys, requests for data and
`presentations. Feedback from these efforts has helped shape the proposals, and the
`Committee wishes to express its gratitude to those who participated in these exercises.
`
`In taking forward this work on an IRB approach, the Committee has sought to
`3.
`develop a framework which is credible, is prudentially sound and that reflects sound credit
`risk management practices in the industry. In addition to providing incentives for individual
`banks, the Committee hopes that, at the same time, the approach will accommodate and
`provide incentives for the ongoing improvement in risk management practices at an
`industry-wide level.
`
`The Committee believes that the best way of securing these objectives is through
`4.
`the adoption of an evolutionary approach to the IRB framework, which mirrors the ongoing
`evolution of credit risk management itself. Banks have made use of internal rating systems
`for a very long time as a means of categorising their exposures into broad, qualitatively
`differentiated layers of risk. Many banks have in recent years made considerable progress in
`enhancing these traditional, qualitatively-oriented internal assessments of credit risk by
`expanding their capabilities for quantifying the credit risk associated with their exposures.
`
`Building upon that capability, for each exposure class (e.g. corporate, retail,
`5.
`sovereign), the IRB approach will provide for a single framework by which a given set of risk
`components or “inputs” are translated into minimum capital requirements. However, in
`respect of some of these risk components, two methodologies for the estimation are
`presented. In its surveys of bank practice and discussions with the industry, the Committee
`has discovered that many banks, including some best-practice banks, currently face
`difficulties in establishing credible and reliable estimates of some risk factors, which can be
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`adequately validated by both the bank and its supervisor. Nonetheless, many of these banks
`can and do provide meaningful and quantifiable estimates of one of the most fundamental
`drivers of credit risk – the risk of default of the obligor. Thus, for these banks, for some
`exposure classes the Committee proposes a foundation methodology in which banks input
`their own assessment of the risk of default of the obligor, but estimates of additional risk
`factors are derived through the application of standardised supervisory rules. The foundation
`methodology will be available to those banks which can demonstrate to supervisors that they
`meet specified minimum requirements in terms of their internal rating systems, risk
`management processes, and ability to estimate the requisite risk components.
`
`The Committee’s work has further revealed that some banks are able (or are likely
`6.
`soon to be able) to provide reliable and consistent estimates of additional risk components.
`These additional components are the likely loss to be incurred should a borrower default, the
`likely level of exposure to that borrower at the time of default, and the effect of guarantees
`and credit derivatives on the risk of the exposure. Thus, sitting alongside the foundation
`methodology are a set of advanced methodologies which allow banks to use their own
`internal assessments of these components. The Committee feels that the wider use of such
`assessments is an important part of a dynamic and risk-sensitive IRB approach, in that it can
`recognise and differentiate those banks which can provide sufficiently robust and quantifiable
`estimates of risk. Furthermore, the use of an advanced methodology more closely aligns
`capital requirements to banks’ internal risk measurement and management practices, and is
`consistent with the philosophy of providing incentives for banks to improve these practices.
`Banks seeking to use one of the advanced methodologies will be required to meet the
`minimum requirements for the foundation methodology and an additional set of specified
`requirements specific to the risk component being estimated.
`
`The ‘evolutionary’ aspect to the IRB approach can be seen in a number of ways.
`7.
`First, over time and at the industry level, the Committee hopes to see more banks moving
`from the standardised approach to the IRB approach, and expects that they will do so when
`they have the requisite systems. Secondly, within the IRB approach, the Committee would
`expect banks to migrate over time from use of the foundation to the more advanced
`methodologies, in line with improvements in their risk management practices. Lastly, the
`Committee envisages that the IRB approach itself will evolve over time. As currently
`configured, the IRB approach allows banks to use many of their own internal risk
`assessments in the derivation of regulatory capital requirements. It stops short, however, of
`permitting banks to calculate their capital requirements on the basis of their own or vendor
`portfolio credit risk models. The Committee explored the use and application of such models
`in its report titled Credit Risk Modelling: Current Practices and Applications, published in April
`1999. It concluded at that stage that it was too early to use the output of such models as a
`basis for setting minimum capital requirements. The Committee continues to believe this to
`be the case.1 Even the advanced IRB methodology will not allow for bank-specific
`adjustments to measures of credit risk to reflect risk correlation between different borrowers
`(in effect, this is the complexity boundary beyond which the IRB approach as currently
`configured will not pass). However, in setting out a framework which contemplates and
`provides appropriate incentives for developments in risk management practices, the
`
`1 The main deficiencies identified by the Committee in using credit risk models as a basis for minimum
`regulatory capital requirements were the quality of data and ability of banks and supervisors to validate model
`outputs. Internal rating systems are a key input into many credit risk models and in this respect these issues –
`data quality and validation – are as important for the IRB approach as they are for credit risk modelling.
`However, in requiring banks to meet rigorous sound practice requirements in terms of the inputs to and
`outputs of a bank’s internal rating system, and importantly ruling out at this stage own assessments of portfolio
`effects such as concentration and diversification, the Committee believes that these deficiencies can be
`overcome in the context of an IRB approach.
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`Committee believes that an approach based on internal ratings could ultimately pave the way
`for a transition towards full portfolio credit risk modelling in the future.
`
`In taking forward the development of an IRB approach, the Committee took as its
`8.
`starting point an approach for corporate, sovereign, and inter-bank exposures. The
`Committee has also developed proposals for retail exposures. The Committee proposes to
`extend the IRB approach to other types of exposures, namely project finance and equity. The
`Committee will continue to develop IRB treatments for these types of exposures over the
`coming months.
`
`The Committee requires that, once a bank uses the IRB approach for one part of its
`9.
`total loan book, it must take steps to implement the IRB approach across all significant
`portfolios and business lines, subject to being able to meet the requisite standards. The
`Committee recognises that for large, diversified internationally active banks, with loan books
`and business units located in many different countries, this requirement may prove to be
`particularly challenging. The Committee, however, views this requirement as being of
`particular importance – both to ensure that minimum capital requirements continue to provide
`prudential coverage and to prevent so-called “cherry-picking” opportunities during the
`transition from partial coverage to full implementation of the IRB approach across group
`companies
`
`As such, the Committee proposes that a banking group that has met the requisite
`10.
`minimum requirements and is utilising the IRB approach for some of its exposures must
`adopt the IRB approach across all exposures and significant business units (groups,
`subsidiaries, and branches) within a reasonably short period of time. Banks must agree to an
`aggressive, articulated rollout plan with the home supervisor. Some