Module: | MODULE B: RISK MANAGEMENT
Q307: Consider the following statements regarding the Internal Ratings-Based (IRB) Approach for Credit Risk under Pillar 1 of Basel II:
1. Under the Foundation IRB approach, banks estimate the Probability of Default, while the regulator provides the Loss Given Default and Exposure at Default.
2. Under the Advanced IRB approach, banks are permitted to use their own internal estimates for Probability of Default, Loss Given Default, Exposure at Default, and Effective Maturity.
3. The IRB approach mandates a flat 100 percent risk weight for all corporate exposures regardless of their default probability.
Which of the statements given above is/are correct?
2. Under the Advanced IRB approach, banks are permitted to use their own internal estimates for Probability of Default, Loss Given Default, Exposure at Default, and Effective Maturity.
3. The IRB approach mandates a flat 100 percent risk weight for all corporate exposures regardless of their default probability.
Which of the statements given above is/are correct?
✅ Correct Answer: A
The correct answer is A. Statement 1 is correct: In the Foundation Internal Ratings-Based (F-IRB) approach, the bank is only responsible for estimating the Probability of Default (PD) for its borrowers.
The regulator supplies the fixed parameters for Loss Given Default (LGD) and Exposure at Default (EAD). Statement 2 is correct: In the Advanced Internal Ratings-Based (A-IRB) approach, banks with highly sophisticated risk models are allowed to provide their own internal estimates for PD, LGD, EAD, and Effective Maturity (M), subject to strict regulatory validation.
Statement 3 is incorrect: The core philosophy of the IRB approach is risk sensitivity.
It explicitly replaces the crude "flat 100 percent risk weight for all corporates" rule found in Basel I. Under IRB, the risk weight dynamically changes based on the calculated risk parameters (PD, LGD, etc.).
The regulator supplies the fixed parameters for Loss Given Default (LGD) and Exposure at Default (EAD). Statement 2 is correct: In the Advanced Internal Ratings-Based (A-IRB) approach, banks with highly sophisticated risk models are allowed to provide their own internal estimates for PD, LGD, EAD, and Effective Maturity (M), subject to strict regulatory validation.
Statement 3 is incorrect: The core philosophy of the IRB approach is risk sensitivity.
It explicitly replaces the crude "flat 100 percent risk weight for all corporates" rule found in Basel I. Under IRB, the risk weight dynamically changes based on the calculated risk parameters (PD, LGD, etc.).