Personal Finance

Based on Advanced Internal Ratings (AIRB)

What is Advanced Internal Ratings Based (AIRB)?

Credit risk measurement based on Advanced Internal Ratings (AIRB) is a method that requires all risk components to be calculated within a financial institution. Based on Advanced Internal Ratings (AIRB) can help institutions reduce their capital requirements and credit risk.

In addition to the basic method estimates based on internal ratings (IRBs), the advanced methods use loss given default (LGD), exposure at default (EAD) and probability of default (PD) to assess default risk. These three elements help determine risk-weighted assets (RWA) as a percentage of the total capital required. ”

key takeaways

  • The Advanced Internal Rating-Based (AIRB) system is an accurate measure of risk factors for financial companies.
  • In particular, AIRB is an internal estimate of credit risk exposure based on isolating specific exposures, such as defaults in its loan portfolio.
  • Using AIRB, banks can simplify their capital requirements by isolating the most severe specific risk factors and downplaying others.

Learn about advanced systems based on internal ratings

Implementing the AIRB approach is one step in the process of becoming a Basel II compliant institution. However, the AIRB approach can only be implemented by institutions that meet certain regulatory standards set out in Basel II.

Basel II is a set of international banking regulations published by the Basel Committee on Banking Supervision in July 2006, extending what was outlined in Basel I. These regulations provide uniform rules and guidelines to balance the international banking sector. Basel II extends the minimum capital requirement rules established under Basel I, provides a framework for regulatory review, and sets disclosure requirements for assessing capital adequacy. Basel II also incorporates credit risk on institutional assets.

Advanced internal rating-based systems and empirical models

The AIRB approach allows banks to estimate many internal risk components themselves. While empirical models vary between institutions, one example is the Jarrow-Turnbull model. The Jarrow-Turnbull model was originally developed and published by Robert A. Jarrow (Kamakura Corporation and Cornell University) and Stuart Turnbull (University of Houston) as a “simplified form” credit model. In contrast to microeconomic models of corporate capital structure, credit models in simplified form focus on describing bankruptcy as a statistical process. (The latter process forms the basis of the common “structured credit model.”) The Jarrow-Turnbull model employs a stochastic interest rate framework. When determining default risk, financial institutions typically use the structured credit model and the Jarrow-Turnbull model.

A system based on advanced internal ratings can also help banks determine Loss Given Default (LGD) and Exposure at Default (EAD). Loss given default is the amount a borrower loses if it defaults; while exposure at default (EAD) is the total value a bank is exposed to in the event of said default.

Advanced internal rating-based system and capital requirements

Capital requirements, set by regulators such as the Bank for International Settlements, the Federal Deposit Insurance Corporation and the Federal Reserve Board, dictate the amount of liquidity that many financial institutions need to hold for a certain level of assets. They also ensure that banks and depository institutions have sufficient capital to withstand operating losses and cash withdrawals. AIRB can help financial institutions determine these levels.

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