Basel IV: Internal Ratings Based Approach (IRBA)

In March 2016, the Basel Committee published proposals on the use of internal ratings-based approaches (IRBA), which massively interfere with the existing designs of the Pillar I IRBA models and essentially comprise three components:

The first change concerns the restriction of internal credit risk approaches for certain portfolios and segments. This follows from the findings of the financial crisis that the credit risk parameters probability of default (PD), loss given default (LGD) and conversion factor (CCF) could not always be modelled reliably to determine capital requirements. According to the Basel Committee, for some portfolios in particular, the essential criteria of data availability, information advantage of banks over the market or the availability of robust modelling procedures cannot be met.

Therefore, IRBA models are no longer to be permitted for banks and "large companies" in the future. The usability of advanced IRBA models (A-IRBA) is to be abolished for "medium-sized enterprises". In addition, IRBA models will no longer be permissible for specialised lending. These requirements of the Basel Committee are currently the subject of controversial discussions and European supervisory authorities are of the opinion that in particular the basic IRBA models should continue to be used for positions vis-à-vis companies and banks as well as for special financing.

The second important change is the introduction of parameter-level floors for the still permissible IRBA portfolios, especially with regard to PD and LGD (e.g. 10% for residential real estate collateralised positions at transaction level, not at portfolio level, and 20% for other tangible collateral). Among other things, the aspects of reliability of the model estimates, reduction of RWA fluctuations as well as the alignment of national special regulations are to be taken into account.

Finally, the Basel Committee intends to limit and specify the methods for estimating the IRBA model parameters through corresponding guard rails. These include proposals for stable through-the-cycle PDs (TTC-PDs), specification with regard to the loss ratio as well as limits on the use of conversion factors, e.g. restriction to selected types of credit facilities. It can be assumed that parameter and method specifications will be introduced for low-default portfolios in particular. Such requirements must also be seen closely in the context of new EBA requirements and the ECB initiative to review internal models (TRIM).

In addition to the foreseeable increase in capital requirements, the new guard rails for calculating the relevant parameters may lead to recalibrations or new developments of models. The effects of changes in the definition of default and materiality thresholds in this context must also be taken into account.

Against this backdrop, we recommend promptly conducting an initial impact analysis on the portfolios, models and minimum capital requirement in order to be able to estimate the effects and implementation efforts. Effects on the business strategy should be analysed and ongoing monitoring of current regulatory developments should be carried out.