The internal-ratings based approach for banks to quantify capital for credit risk – a framework deployed by over 100 banks, from Europe to China and Australia – is in crisis. While the Fed has been consistently sceptical of it, European regulators at the Basel level have adopted an ambivalent posture by first encouraging lenders to adopt it, only to then sound the alarm over inconsistences in risk weights.
In 2013, the European Union adopted the Capital Requirements Directive, which sought to reduce systemic reliance on credit ratings by encouraging banks to calculate their own ratings; and to make bank-capital more risk-sensitive, letting lenders use these calculations in their own risk-management or economic capital models. So while the IRB approach was developed for large, internationally active banks by Basel in the early 2000s, the CRD opened it up for use by all banks in Europe.
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We can build models for IRB-regulatory purposes and for economic capital models, which will help banks to manage their business
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However, regulators now reckon the IRB framework gives lenders too much flexibility, shown by the variance between different banks’ assessments of the creditworthiness of the same individual borrowers or groups of borrowers and, by implication, the capital requirements set aside for exposure to them.