APPENDIX B 3 • 19APPENDIX B: BIS II TREATMENT OF RETAIL EXPOSURES UNDER THE
INTERNAL RATINGS-BASED APPROACH
The retail portfolio is defined as a “large number of small, low value loans with ei-
ther a consumer or a business focus, in which the incremental risk of any particular
exposure is small.”^53 (BIS, 2001a), “The Internal Ratings-Based Approach,” p. 59.)
This includes: credit cards, installment loans (e.g., personal finance, education loans,
auto loans, leasing), revolving credits (e.g., overdrafts, home equity lines of credit),
residential mortgages, and small business facilities. To be considered “retail,” the
loans must be managed by the bank as a large pool of fairly homogeneous loans. The
retail loan portfolio is typically divided into segments based on each segment’s PD,
LGD, and EAD. For each loan, the bank determines the EAD and multiplies that by
the risk weight,^54 which in turn is dependent on a benchmark risk weight following
the methodology shown in equation (2), but calibrated to different constants as fol-
lows:
(B1)The term , where reflects the variables in equation (4), denotes the cumulative
distribution function for a standard normal random variable (i.e., the probability that
a normal random variable with mean zero and variance of one is less than or equal to
) and the term , where reflects the term in brackets in equation (B1), denotes
the inverse cumulative distribution function for a standard normal random variable
(i.e., the value such that ). The risk weight formula is calibrated to a three
year retail loan maturity with a LGD = 50%. As for corporate loans, the BRW is sub-
stituted into equation (1) to determine the retail loan’s risk weight. In Exhibit B.1, the
benchmark risk weights for retail loans are compared to the BRW for corporate loans;
both sets of loans assume a three-year maturity and a LGD = 50%. As shown in Ex-
hibit 3B.1, retail loans have lower benchmark risk weights for every value of PD re-
flecting lower minimum captial requirements for the retail sector.^55
In July 2002, the Basel Committee on Banking Supervision published potential
modifications to the BIS II proposals for retail obligations. Under the modifications
(if adopted) residential mortgages would have a higher risk weight curve than other
retail exposures, but both retail risk weight curves would be lower than the one spec-
ified in equation (B1) under the BIS II proposals.
The residential mortgage risk weight curve under the IRB Approach is:^56
(B2)BRW12.50 LGD N 311 R 2 .0.5 G 1 PD 2 1 R>1 1 R 22 0.5 G 1 0.999 24y N 1 y 2 zy G 1 z 2 z
N 1 y 2 yBRW976.5N 1 1.043 G 1 PD 2 0.766 2 11 .0470 11 PD2>PD0.44 2(^53) BIS 2001, “The Internal Ratings-Based Approach,” p. 59.
(^54) If EAD cannot be determined, the bank can use an estimate of expected losses, or PD LGD.
(^55) The lower retail capital charges reflect BIS concern that certain retail portfolios may generate ex-
pected margin income sufficient to cover expected losses (EL). Thus, the proposed risk weights, which
cover both EL and UL, may overstate capital requirements.
(^56) There is no distinction between IRB Foundation and Advanced for retail credits.