INTERNAL RATING BASED APPROACH: A TOOL IN CREDIT RISK MANAGEMENT

Credit Risk is defined as a potential risk that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.

- Ranjan Kumar Sahoo

It can also be due to the deterioration of creditworthiness of a debt instrument issuer or even in down gradation of credit rating of a pool of credit portfolio. The goal of credit risk management is to maximize a bank's risk-adjusted rate of return by maintaining credit risk exposure within the acceptable levels. If we closely watch any Bank's composition of risk-weighted assets we can find that major contributor is credit risk.

The Basel II Framework presents two approaches for calculating credit risk capital charge in a continuum of increasing sophistication and risk sensitivity:

1. Standardised Approach and

2. Internal Rating Based (IRB) Approach:

I. Foundation Internal Rating Based (FIRB) Approach,

II. Advanced Internal Rating Based (AIRB) Approach.

Why internal rating-based approach?

In the standardized approach, the risk weights for different exposures are specified by the regulator. To determine the risk weights for the standardized approach, the bank can take the help of external credit rating agencies that are recognised as eligible by Reserve Bank of India. In this approach banks were relying mechanically on external rating and the granularity, as well as risk sensitivity with respect to the expertise of individual bank, was absent. On the contrary in IRB each bank can have its model with approval from the regulator and a bank with robust credit monitoring mechanism can save precious capital with lower risk-weighted assets.

Internal Rating Based (IRB) Approach