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FRM Part II · FRM Exam Part II · Capital Regulation Before the Global Financial Crisis

A risk manager compares the foundation IRB (F-IRB) and advanced IRB (A-IRB) approaches under Basel II for corporate exposures. Which statement correctly describes the difference?

Under foundation IRB the bank estimates only the probability of default and relies on supervisory values for loss given default, exposure at default and generally maturity. Under advanced IRB the bank also estimates LGD, EAD and maturity itself, subject to supervisory approval.

  1. AUnder F-IRB the bank estimates PD, LGD, EAD and maturity itself, while under A-IRB it estimates only PD
  2. BUnder F-IRB the bank estimates PD and supervisors provide LGD, EAD and, in general, maturity, while under A-IRB the bank estimates all of them subject to approvalCorrect
  3. CUnder F-IRB the bank uses external ratings for PD, while under A-IRB it uses internal ratings
  4. DUnder both approaches supervisors set PD, but A-IRB lets banks choose the asset correlation

Explanation

In F-IRB banks supply their own PD estimates; supervisory values are used for LGD and EAD (and maturity is fixed at 2.5 years unless national discretion applies). In A-IRB banks also estimate LGD, EAD and maturity. Asset correlation is set by the supervisory formula in both.

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