Background:

The Basel Committee on Banking Supervision (BCBS) has revised the credit risk framework as part of the Basel III reform package. The revisions seek to restore the credibility in the calculation of risk-weighted assets (RWAs) and improve the comparability of banks’ capital ratios.

As under Basel II, the revised credit risk framework provides two main approaches for calculating credit RWAs: -Standardized approach (SA) – Under the SA, banks use a prescribed risk weight schedule for calculating
RWAs. Similarly to Basel II, the risk weights depend on asset class and are generally linked to external ratings, but several enhancements and changes have been introduced.

-Internal ratings-based (IRB) approach – Under the IRB approach, banks can use their internal rating systems for credit risk, subject to the explicit approval of their respective supervisors. Similarly to Basel II, banks can use either the advanced IRB approach (ie use their internal estimates of risk parameters such as probability of default (PD), loss-given default (LGD) and exposure-at-default (EAD)) or the foundation IRB approach (ie use only their internal estimates of PD). However, enhancements to and constraints on the application of IRB approaches for certain asset classes have been introduced under Basel III.

More specifically the changes incorporate:
• A more granular approach for unrated exposures to banks and corporates;
• A recalibration of risk weights (RW) for rated exposures;
• Separate treatments for covered bonds, specialized lending and SME exposures;
• A more risk-sensitive approach for real estate exposures based on a loan-to-value ratio (LTV) and recognizing exposures materially dependent
on cashflows generated by property;