The IRB Approach in the Basel Committee's Proposal for New Capital Adequacy Rules: Some Simulation-Based Illustrations

Abstract

The Internal Ratings Based (IRB) approach for determining banks' capital adequacy is one of the cornerstones of the Basel Committee's proposed revision of the Basel Accord for banking regulation. This article presents the ideas behind the IRB approach and its fundamental features, and discusses the consequences of a number of its components for the banks' capital adequacy requirements. Using a simulation-based analysis, we will illustrate the relationship between IRB-determined capital and the risks inherent in a loan portfolio in a dynamic perspective assuming different macroeconomic developments.1 We will also examine the effect of the number of risk classes that banks use and of different risk profiles of their credit portfolios.

Keywords: IRB, Basel II, internal ratings, loan portfolio, credit risk, macroeconomic development

JEL Classification: C15, G21, G32, E58