Credit Risk - IRB - Forvis Mazars

The focus is on reducing the complexity of the approaches and improving comparability across firms. However, PRA has decided to take a ‘gold plated’ approach to IRB in some areas where their proposals are more conservative than the Basel standards. This includes the removal of the IRB approach for Sovereigns, more conservative input floors (mortgages), and broader application of the asset value correlation multiplier for financials.

Use of the IRB approach has been restricted for low-risk exposures including, central governments and central banks, quasi-sovereigns and equity, where RWAs will be required to be calculated using the Standardised Approach. The Advanced IRB approach is now restricted for exposures to institutions, financial corporates and large corporates.

The PRA will grant firms permission to use IRB models if their models can demonstrate ‘material compliance’ with UK CRR. This includes permissions for model changes. This is to address a competitive disadvantage for firms aspiring to IRB as firms with permissions already are not required to remediate immaterial non-compliance. Firms can now apply for IRB for some exposure classes while allowing others to remain on the SA. In the past, this mix-and-match approach was not normally allowed.

However, one example of where the near-final rules are intended to reduce the benefits of the IRB Approach and bring them into closer alignment with the Standardised Approach relates to the Probability of Default estimation framework. Here the PRA are prohibiting the use of continuous scales in PD models. This decision is likely to reduce the risk sensitivity of PD estimates in IRB mode

What banks should consider:

For mid-tier firms, the reduced benefit of the IRB approach versus the Standardised approach may dissuade application for use of model permissions. Firms will need to carefully consider whether the advantages of better capital treatment outweigh the time and costs associated with applying for model permissions.
This will include ensuring that the output floor doesn’t become a binding constraint on obtaining any benefits from IRB.
Firms will need to review the qualitative expectations associated with application of PD, LGD and EAD to understand how the proposals will impact their current IRB model approach. This is because some of the current methodologies that are commonplace in the industry will no longer conform to regulatory guidance.

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