Credit Risk – The Standardised Approach

50. The Committee permits banks a choice between two broad methodologies for calculating their capital requirements for credit risk.

One alternative, the Standardised Approach, will be to measure credit risk in a standardised manner, supported by external credit assessments. *

* The notations follow the methodology used by one institution, Standard & Poor’s. The use of Standard & Poor’s credit ratings is an example only; those of some other external credit assessment institutions could equally well be used.

The ratings used throughout this document, therefore, do not express any preferences or determinations on external assessment institutions by the Committee.

51. The other alternative, the Internal Ratings-based Approach, which is subject to the explicit approval of the bank’s supervisor, would allow banks to use their internal rating systems for credit risk.

52. The following section sets out revisions to the 1988 Accord for risk weighting banking book exposures.

Exposures that are not explicitly addressed in this section will retain the current treatment; however, exposures related to securitisation are dealt with in Section IV.

Furthermore, the credit equivalent amount of Securities Financing Transactions (SFT) * and OTC derivatives that expose a bank to counterparty credit risk ** is to be calculated under the rules set forth in Annex 4 ***.

In determining the risk weights in the standardised approach, banks may use assessments by external credit assessment
institutions recognised as eligible for capital purposes by national supervisors in accordance with the criteria defined in paragraphs 90 and 91.

Exposures should be risk-weighted net of specific provisions. ****

* Securities Financing Transactions (SFT) are transactions such as repurchase agreements, reverse repurchase agreements, security lending and borrowing, and margin lending transactions, where the value of the transactions depends on the market valuations and the transactions are often subject to margin agreements.

** The counterparty credit risk is defined as the risk that the counterparty to a transaction could default before the
final settlement of the transaction’s cash flows.

An economic loss would occur if the transactions or portfolio of transactions with the counterparty has a positive economic value at the time of default.

Unlike a firm’s exposure to credit risk through a loan, where the exposure to credit risk is unilateral and only the lending bank
faces the risk of loss, the counterparty credit risk creates a bilateral risk of loss: the market value of the transaction can be positive or negative to either counterparty to the transaction.

The market value is uncertain and can vary over time with the movement of underlying market factors.

*** Annex 4 of this Framework is based on the treatment of counterparty credit risk set out in Part 1 of the Committee’s paper The Application of Basel II to Trading Activities and the Treatment of Double Default Effects (July 2005).

**** A simplified standardised approach is outlined in Annex 11

A. Individual claims
1. Claims on sovereigns

53. Claims on sovereigns and their central banks will be risk weighted as follows:

54. At national discretion, a lower risk weight may be applied to banks’ exposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded * in that currency **.

Where this discretion is exercised, other national supervisory authorities may also permit their banks to apply the same risk weight to domestic currency exposures to this sovereign (or central bank) funded in that currency.

* This is to say that the bank would also have corresponding liabilities denominated in the domestic currency.

** This lower risk weight may be extended to the risk weighting of collateral and guarantees. See Sections II.D.3
and II.D.5.

55. For the purpose of risk weighting claims on sovereigns, supervisors may recognise the country risk scores assigned by Export Credit Agencies (ECAs).

To qualify, an ECA must publish its risk scores and subscribe to the OECD agreed methodology.

Banks may choose to use the risk scores published by individual ECAs that are recognised by their supervisor, or the consensus risk scores of ECAs participating in the “Arrangement on Officially Supported Export Credits”.*

The OECD agreed methodology establishes eight risk score categories associated with minimum export insurance premiums.

These ECA risk scores will correspond to risk weight categories as detailed below.

* The consensus country risk classification is available on the OECD’s website (http://www.oecd.org) in the
Export Credit Arrangement web-page of the Trade Directorate.

56. Claims on the Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community may receive a 0% risk weight.

2. Claims on non-central government public sector entities (PSEs)

57. Claims on domestic PSEs will be risk-weighted at national discretion, according to either option 1 or option 2 for claims on banks. *

When option 2 is selected, it is to be applied without the use of the preferential treatment for short-term claims.

* This is regardless of the option chosen at national discretion for claims on banks of that country.

It therefore does not imply that when one option has been chosen for claims on banks, the same option should also be
applied to claims on PSEs.

58. Subject to national discretion, claims on certain domestic PSEs may also be treated as claims on the sovereigns in whose jurisdictions the PSEs are established.*

Where this discretion is exercised, other national supervisors may allow their banks to risk weight claims on such PSEs in the same manner.

* The following examples outline how PSEs might be categorised when focusing on one specific feature, namely revenue raising powers.

However, there may be other ways of determining the different treatments applicable to different types of PSEs, for instance by focusing on the extent of guarantees provided by the central government:

- Regional governments and local authorities could qualify for the same treatment as claims on their sovereign or central government if these governments and local authorities have specific revenue raising powers and have specific institutional arrangements the effect of which is to reduce their risks of default.

- Administrative bodies responsible to central governments, regional governments or to local authorities and other non-commercial undertakings owned by the governments or local authorities may not warrant the same treatment as claims on their sovereign if the entities do not have revenue raising powers or other arrangements as described above.

If strict lending rules apply to these entities and a declaration of bankruptcy is not possible because of their special public status, it may be appropriate to treat these claims in the same manner as claims on banks.

- Commercial undertakings owned by central governments, regional governments or by local authorities may be treated as normal commercial enterprises.

However, if these entities function as a corporate in competitive markets even though the state, a regional authority or a local authority is the major shareholder of these entities, supervisors should decide to consider them as corporates and therefore
attach to them the applicable risk weights.

3. Claims on multilateral development banks (MDBs)

59. The risk weights applied to claims on MDBs will generally be based on external credit assessments as set out under option 2 for claims on banks but without the possibility of using the preferential treatment for short-term claims.

A 0% risk weight will be applied to claims on highly rated MDBs that fulfil to the Committee’s satisfaction the criteria provided
below.

The Committee will * continue to evaluate eligibility on a case-by-case basis.

The eligibility criteria for MDBs risk weighted at 0% are:

• very high quality long-term issuer ratings, i.e. a majority of an MDB’s external assessments must be AAA;

• shareholder structure is comprised of a significant proportion of sovereigns with long-term issuer credit assessments of AA- or better, or the majority of the MDB’s fund-raising are in the form of paid-in equity/capital and there is little or no leverage;

• strong shareholder support demonstrated by the amount of paid-in capital contributed by the shareholders; the amount of further capital the MDBs have the right to call, if required, to repay their liabilities; and continued capital contributions
and new pledges from sovereign shareholders;

• adequate level of capital and liquidity (a case-by-case approach is necessary in order to assess whether each MDB’s capital and liquidity are adequate); and,

• strict statutory lending requirements and conservative financial policies, which would include among other conditions a structured approval process, internal creditworthiness and risk concentration limits (per country, sector, and individual
exposure and credit category), large exposures approval by the board or a committee of the board, fixed repayment schedules, effective monitoring of use of proceeds, status review process, and rigorous assessment of risk and provisioning to loan loss reserve.

* MDBs currently eligible for a 0% risk weight are: the World Bank Group comprised of the International Bank for Reconstruction and Development (IBRD) and the International Finance Corporation (IFC), the Asian Development Bank (ADB), the African Development Bank (AfDB), the European Bank for Reconstruction and Development (EBRD), the Inter-American Development Bank (IADB), the European Investment Bank (EIB), the European Investment Fund (EIF), the Nordic Investment Bank (NIB), the Caribbean Development Bank (CDB), the Islamic Development Bank (IDB), and the Council of Europe Development Bank (CEDB).

4. Claims on banks

60. There are two options for claims on banks. National supervisors will apply one option to all banks in their jurisdiction. No claim on an unrated bank may receive a risk weight lower than that applied to claims on its sovereign of incorporation.

61. Under the first option, all banks incorporated in a given country will be assigned a risk weight one category less favourable than that assigned to claims on the sovereign of that country. However, for claims on banks in countries with sovereigns rated BB+ to B- and on banks in unrated countries the risk weight will be capped at 100%.

62. The second option bases the risk weighting on the external credit assessment of the bank itself with claims on unrated banks being risk-weighted at 50%.

Under this option, a preferential risk weight that is one category more favourable may be applied to claims with an original maturity * of three months or less, subject to a floor of 20%.

This treatment will be available to both rated and unrated banks, but not to banks risk weighted at 150%.

* Supervisors should ensure that claims with (contractual) original maturity under 3 months which are expected to be rolled over (i.e. where the effective maturity is longer than 3 months) do not qualify for this preferential treatment for capital adequacy purposes.

63. The two options are summarised in the tables below.

* Short-term claims in Option 2 are defined as having an original maturity of three months or less.

These tables do not reflect the potential preferential risk weights for domestic currency claims that banks may be allowed to
apply based on paragraph 64.

64. When the national supervisor has chosen to apply the preferential treatment for claims on the sovereign as described in paragraph 54, it can also assign, under both options 1 and 2, a risk weight that is one category less favourable than that assigned to claims on the sovereign, subject to a floor of 20%, to claims on banks of an original maturity of 3 months or
less denominated and funded in the domestic currency.

5. Claims on securities firms

65. Claims on securities firms may be treated as claims on banks provided these firms are subject to supervisory and regulatory arrangements comparable to those under this Framework (including, in particular, risk-based capital requirements).

Otherwise such claims would follow the rules for claims on corporates.

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