All entities face uncertainties that can hinder their objectives or goals from materializing. These uncertainties are known as risks. Usually, these come from several sources or can generate from different factors. The term risk represents the difference between actual and expected outcomes. Usually, these outcomes are significantly crucial for companies and all businesses.
Every entity faces a different type of risk based on its operations or nature. For most companies, these risks may encompass financial and non-financial risks. These risks can result in significant losses for entities when they materialize. Usually, these entities employ several measures to prevent any unexpected results or financial losses. However, eliminating these may not be an option. Therefore, entities will have to settle for reducing them to a minimum.
The approaches that entities take to tackle risks depend on several factors. Some of these approaches may come from an entity’s internal risk management processes. However, others may also come from guidelines or benchmarks. For the financial institutions’ sector, one of the most critical risks involves credit risks. For that, they may use an advanced internal rating-based (AIRB or Advanced IRB) approach.
The advanced internal rating-based approach relates to credit risks. Therefore, it is crucial to understand what those risks are first.
What are Credit Risks?
Credit risk is a type of uncertainty that relates to a borrower’s ability to repay a loan. Most financial institutions indulge in providing loans to borrowers as lenders. For most of them, the primary source of income involves interest payments from borrowers. Usually, these institutions perform various checks on a borrower to ensure they will receive their loans back.
Sometimes, however, borrowers may not have the financial resources to repay loans. In some cases, they may also intentionally do so. Either way, if they do not repay the loan, their lender will suffer losses. Despite the checks that most financial institutions perform, chances of such instances occurring still exist. These changes or possibilities encompass the credit risk for the lender.
Therefore, credit risk is the possibility that a borrower fails to repay a loan. However, it may also include any other contractual obligations that come with those loans, for example, interest payments. Since these instances result in losses for the lender, they constitute credit risk. This risk can result in the interruption of cash flows for the lender and increased collection costs.
Credit risk is one of the most significant risks that lenders and financial institutions face. While most financial institutions strive to eliminate these risks, it is impossible to do so. Instead, they can seek to reduce these risks to the least possible level. By doing so, they can decrease the losses associated with such instances. In contrast, if the credit risks materialize, lenders may incur significant losses.
Overall, credit risk is any uncertainties associated with loans. More specifically, it is the possibility of a borrower failing to repay their loan and causing significant losses. These risks cover both the principal and interest payment associated with a loan transaction. Most lenders can reduce these risks to a specific level. However, they are not completely eliminable and will always exist.
What is Advanced Interest Rating-Based (AIRB) approach?
An advanced internal rating-based approach is a measurement technique to establishing credit risks. In other words, it is a risk measurement tool for lenders, more specifically financial institutions and banks. This approach helps those entities measure their credit risks. The advanced internal rating-based approach falls under the Basel II Capital Rules for institutions and companies specializing in banking globally.
The advanced internal rating-based approach requires financial institutions to measure risks internally. This way, these institutions can develop their own empirical models to establish the required capital for credit risk. Therefore, it can reduce the capital requirements and capital risk of a financial institution. It can also prove to be a significantly crucial tool in understanding overall credit risks.
Under the AIRB approach, financial institutions must use internal quantitative models to estimate three elements. These include the probability of default (PD), exposure at default (EAD) and loss given default (LGD). Apart from these, they must also establish some other parameters. These are crucial factors in calculating the risk-weighted average (RWA). After that, they can then calculate the total required capital, which is a fixed percentage of RWA.
The advanced internal rating-based approach is crucial for financial institutions to comply with the Basel II accord. This accord includes a set of international banking regulations issued by the Based Committee on Bank Supervision. However, this approach only relates to a specific supervisory standard outline in that accord. Similarly, financial institutions can only use this approach subject to approval from their local regulators.
Overall, the advanced internal rating-based approach allows financial institutions to measure their credit risk and capital requirements. There is a wide range of assumptions that underpin the IRB capital model. However, it does not introduce to require a standard way to achieve that. Instead, this approach allows financial institutions to use their own inputs to calculate the risk-weighted assets.
What are the components of the Advanced Internal Rating-Based (AIRB) approach?
The advanced internal rating-based (AIRB) approach helps financial institutions measure their credit risks and capital requirements. For that, it requires various components, which are essential in both of the above. These components are also a part of the Basel II accord. Overall, the primary components of the advanced internal rating-based approach include the following.
Probability of Default (PD)
The probability of default (PD) is the probability of the borrower defaulting on contractual obligations. In some cases, it may also refer to the probability of an asset not generating any returns. Usually, it depends on a borrower’s characteristics. However, it may also relate to the economic environment in which a financial institution operates. The probability of defaulting on a loan increases the interest rate charged by the lender.
Exposure at default (EAD)
Exposure at default refers to the value to which a financial institution is exposed when a loan defaults. Simply put, it represents the total predicted amount of loss suffered in case a borrower fails to honor their contractual obligations. Another name used for exposure at default is credit exposure. Usually, this value differs from one loan transaction to another. Financial institutions can use two methods to determine exposure at default, including the AIRB method.
Loss Given Default (LGD)
The term loss given default (LGD) represents the amount of money a financial institution loses in case of a default. However, it differs from the exposure at default as it represents a percentage of that total exposure. Financial institutions calculate this percentage after considering all outstanding loans using cumulative losses and exposure. Several methods help financial institutions to calculate the loss given default.
Risk-Weighted Assets (RWA)
The above three components, along with other parameters, help calculate the risk-weighted assets. This term refers to an asset classification system used to determine the minimum capital for banks to maintain as reserves. This capital requirement helps banks reduce their insolvency risk. Similarly, this requirement is based on a risk assessment for each type of bank asset. By maintaining the capital requirements, banks can mitigate their credit risks.
Credit risk refers to the probability of losses occurring from borrowers failing to satisfy their contractual obligations. For financial institutions, the advanced internal rating-based (AIRB) approach helps in measuring those credit risks. Similarly, this approach helps establish the credit requirements that these institutions must maintain. There are several crucial components for this approach, as mentioned above.