The term “Advanced Internal Rating-Based” (AIRB) refers to a set of risk measurement and management approaches used by banks to assess credit risk. The AIRB framework is part of the Basel II Accord, which is an international regulatory framework developed by the Basel Committee on Banking Supervision. Basel II aims to improve the measurement and management of various risks faced by banks, including credit risk.
The AIRB approach allows banks to use their internal models to estimate credit risk parameters for individual borrowers or counterparties. These internal models are considered more sophisticated and reflective of a bank’s specific risk profile compared to the standardized approaches outlined in Basel II.
There are two main components within the AIRB framework:
1. **Foundation Internal Ratings-Based (FIRB):** Under the FIRB approach, banks are allowed to use their internal models to estimate the probability of default (PD), exposure at default (EAD), and loss given default (LGD) for individual borrowers. However, the regulator sets the risk-weighted assets (RWA) calculation formula, which incorporates the internal estimates.
2. **Advanced Internal Ratings-Based (AIRB):** The AIRB approach provides banks with more flexibility as they are permitted to use their internal models not only for estimating credit risk parameters but also for determining the RWA calculation formula. This allows banks to have more influence over the risk weights assigned to different types of assets based on their internal assessments.
Key components of the AIRB approach include:
– **Probability of Default (PD):** The likelihood that a borrower will default on its obligations over a specific time horizon.
– **Exposure at Default (EAD):** The expected amount of exposure a bank would face in the event of a borrower’s default.
– **Loss Given Default (LGD):** The proportion of exposure that would be lost in the event of a borrower’s default.
Banks adopting the AIRB approach are subject to rigorous regulatory requirements, including the need to demonstrate the robustness and accuracy of their internal models. The goal of the AIRB framework is to align capital requirements more closely with the actual risk profiles of individual borrowers, promoting better risk management practices within the banking sector.
It’s important to note that the Basel regulatory framework has evolved, and subsequent revisions, such as Basel III, have introduced further enhancements to the measurement and management of credit risk. The choice between standardized and internal rating-based approaches depends on the size, complexity, and sophistication of the banking institution.