What Is an Advanced Internal Rating-Based (AIRB) Approach?

What Is Advanced Internal Rating-Based (AIRB)?

An advanced internal rating-based (AIRB) approach to credit risk measurement is a method that requests that all risk components be calculated internally within a financial institution. Advanced internal rating-based (AIRB) can help an institution reduce its capital requirements and credit risk.

In addition to the basic internal rating-based (IRB) approach estimations, the advanced approach assesses the risk of default using loss given default (LGD), exposure at default (EAD), and the probability of default (PD). These three elements help determine the risk-weighted asset (RWA) that is calculated on a percentage basis for the total required capital.”

Understanding Advanced Internal Rating-Based Systems

Implementing the AIRB approach is one step in the process of becoming a Basel II-compliant institution. However, an institution may implement the AIRB approach only if they comply with certain supervisory standards outlined in the Basel II accord.

Basel II is a set of international banking regulations, issued by the Basel Committee on Bank Supervision in July 2006, which expand upon those outlined in Basel I. These regulations provided uniform rules and guidelines to level the international banking field. Basel II expanded the rules for minimum capital requirements established under Basel I, provided a framework for regulatory review, and set disclosure requirements for assessment of capital adequacy. Basel II also incorporates credit risk of institutional assets.

Advanced Internal Rating-Based Systems and Empirical Models

The AIRB approach allows banks to estimate many internal risk components themselves. While the empirical models among institutions vary, one example is the Jarrow-Turnbull model. Originally developed and published by Robert A. Jarrow (Kamakura Corporation and Cornell University), along with Stuart Turnbull, (University of Houston), the Jarrow-Turnbull model is a “reduced-form” credit model. Reduced form credit models center on describing bankruptcy as a statistical process, in contrast with a microeconomic model of the firm’s capital structure. (The latter process forms the basis of common “structural credit models.”) The Jarrow–Turnbull model employs a random interest rates framework. Financial institutions often work with both structural credit models and Jarrow-Turnbull ones, when determining the risk of default.

Advanced Internal Rating-Based systems also help banks determine loss given default (LGD) and exposure at default (EAD). Loss given default is the amount of money to be lost in the event of a borrower default; while exposure at default (EAD) is the total value a bank is exposed to at the time of said default.

Advanced Internal Rating-Based Systems and Capital Requirements

Set by regulatory agencies, such as the Bank for International Settlements, the Federal Deposit Insurance Corporation, and the Federal Reserve Board, capital requirements set the amount of liquidity is needed to be held for a certain level of assets at many financial institutions. They also ensure that banks and depository institutions have enough capital to both sustain operating losses and honor withdrawals. AIRB can help financial institutions determine these levels.