2.Risk components—PD and EAD for the Foundation model and PD, EAD,
LGD, and M for the Advanced model.
3.A risk weight function that uses the risk components to calculate the risk
weights.
4.A set of minimum requirements of eligibility to apply the IRB approach (i.e.,
demonstration that the bank maintains the necessary information systems to ac-
curately implement the IRB approach).
5.Supervisory review of compliance with the minimum requirements.(a) Foundation IRB Approach. The bank is allowed to use its own estimate of PD
over a one-year time horizon, as well as each loan’s EAD. However, there is a lower
bound on PD that is equal to three basis points, so as to create a nonzero floor on the
credit risk weights (and hence capital required to be held against any individual loan).
The average PD for each internal grade is used to calculate the risk weight for each
internal rating. The PD may be based on historical experience or even potentially on
a credit scoring model (see Saunders and Allen (2002) for discussions of traditional
credit scoring models as well as newer, more theory-based models). The EAD for on-
balance-sheet transactions is equal to the nominal (book) amount of the exposure out-
standing. Credit mitigation factors (e.g., collateral, credit derivatives or guarantees,
on-balance-sheet netting) are incorporated following the rules of the Standardized
IRB Approach by adjusting the EAD for the collateral amount, less a haircut deter-
mined by supervisory advice under Pillar II. The EAD for off-balance-sheet activi-
ties is computed using the BIS I approach of translating off-balance-sheet items into
on-balance-sheet equivalents mostly using the BIS I conversion factors (see Saunders
(1997), Chapter 20).^38 The Foundation IRB Approach sets a benchmark for M, Ma-
turity (or Weighted Average Life of the loan) at three years (in November 2002, this
was changed to 2.5 years). Moreover, the Foundation Approach assumes that Loss
Given Default for each unsecured loan is set at LGD = 50% for senior claims and
LGD = 75% for subordinated claims on corporate obligations.^39 However, in No-
vember 2001, the Basel Committee on Banking Supervision presented potential mod-
ifications that would reduce the LGD on secured loans to 45% if fully secured by
physical, non–real estate collateral and 40% if fully secured by receivables.
Under the January 2001 proposal, the Foundation Approach formula for the risk
weight on corporate obligations (loans) is:^40
(1)where the benchmark risk weight (BRW) is calculated for each risk classification
using the following formula:
(2)BRW976.5 N 1 1.118 G 1 PD 2 1.288 2 1 .0470 11 PD2>PD0.44RW 1 LGD> 502 BRW or 12.50 LGD, whichever is smaller3.4 INTERNAL RATINGS-BASED MODELS FOR CREDIT RISK 3 • 11(^38) However, there is now a 20% conversion factor for loan commitments maturing in less than one
year. Under BIS I this conversion factor was 0%.
(^39) The Foundation Approach assumes a constant LGD. Altman and Brady (2001) find that LGD is di-
rectly related to PD.
(^40) PD is expressed in decimal format in all formulas.