Capital requirements for credit risks
The Capital Requirements Regulation (CRR) contains two alternative approaches to determine the capital requirements for credit risk: the so-called credit risk standardised approach (CRSA) and an internal ratings-based approach (IRBA).
Under the CRSA, for certain exposure classes institutions may determine the risk-weighting of credit risk positions on the basis of external credit ratings. One condition for so doing is that these ratings have been published by recognised rating agencies or by export credit insurance agencies.
Depending on the external credit rating, credit risk exposures are allocated risk-weightings per exposure class of 0%, 10%, 20%, 50%, 100%, 150%, 225%, 350%, 650% or 1,250%. For credit risk exposures for which no external rating is available, fixed risk-weightings are laid down. In addition, however, under the CRSA there are also exposure classes in which external credit ratings will generally play no role for risk-weighting purposes. For these, only fixed risk-weightings that take into account only the type of credit risk exposure will be used.
Credit risk mitigation techniques eligible under the CRSA
Institutions can mitigate (i.e. reduce) credit risk through financial collateral and guarantees. Under the CRSA, in addition to the simple method for the purposes of taking into account financial collateral, institutions can also make use of the more comprehensive method, which, however, is more sophisticated.
With the simple method, the risk-weighting of the debtor is in essence replaced by the risk-weighting of the collateral (risk-weighting substitution). With the more sophisticated variant, however, the calculation base is reduced by the amount of the collateralisation, with the term of the instrument providing the security and possible fluctuations in the value and exchange rate also being taken into account. For this purpose institutions can also make use of their own estimates in order to estimate the fluctuations in value and exchange rates. Guarantees are uniformly taken into account by risk-weighting substitution, with the term and the currency being taken into account.
Internal ratings-based approach
With the IRB approach (IRBA – internal ratings-based approach), in addition to the CRSA, institutions are able to avail themselves of a further, more risk-sensitive approach to the risk-weighting of credit risk exposures. If operating within the IRBA, a further distinction can be drawn between whether, beyond its retail business, an institution estimates only the probability of default/PD (foundation approach) itself or whether it also estimates the loss given default/LGD and the conversion factor (advanced approach).
With both variants, internal rating systems are used to determine the capital requirements for credit risk. Each borrower is allocated to a particular rating category on the basis of internal credit ratings. The risk-weighting to be applied to a credit risk position primarily takes into account the probability of the borrower not meeting his payment obligations (or not meeting them in full). The institution can estimate the probability of default for all borrowers in the same rating category on the basis of historical data.
IRBA institutions may estimate risk mitigation themselves
Institutions can mitigate (i.e. reduce) credit risk through collateral and guarantees. Under the IRBA there is an even wider range of collateral that may be taken into account than under the CRSA. IRBA institutions which also estimate the loss given default and the conversion factor themselves may even calculate the scale of the risk mitigation themselves. The condition is that they have suitable internal rating systems in place.
IRBA only with authorisation from BaFin
Institutions that opt to use the IRBA require authorisation from BaFin. For institutions that opt to use an internal rating system or an equity risk model to determine the institution’s capital requirements for credit risk under the IRBA, prior approval from BaFin is additionally required. BaFin will grant this approval based on the results of a suitability examination. Any major changes or amendments to the scope of application must also be authorised by BaFin.
The German Solvency Regulation (Solvabilitätsverordnung – SolvV), applicable as from 1 January 2014, contains provisions on the procedures to be implemented to comply with the application and notification requirements stipulated by the CRR. Such requirements include the periodical reporting requirement, in particular with regard to the form in which applications have to be submitted and to whom notifications and reports to BaFin have to be submitted.
Overview of IRBA institutions
BaFin has provided an overview of the institutions and groups of institutions that have approval to use the IRBA. In addition, the review makes it clear whether the IRBA approval for groups of institutions has been granted for capital requirements on a consolidated basis only or whether it also applies on an individual basis to the parent company in question.