BIPRU 4.1 The IRB approach: Application, purpose and overview
Application
1BIPRU 4 applies to a firm with an IRB permission.
Purpose
BIPRU 4 implements the following provisions of the Banking Consolidation Directive:
BIPRU 4 also implements Annex VIII of the Banking Consolidation Directive so far as it applies to the IRB approach. In particular, it implements (in part):
BIPRU 4 also implements article 40 of the Capital Adequacy Directive as it applies to the IRB approach.
Other material on the IRB approach can be found in BIPRU 8 (Group risk), BIPRU 9 (Securitisation), BIPRU 13 (The calculation of exposure values for financial derivatives, securities financing transactions and long settlement transactions) and BIPRU 14 (Capital requirements for settlement and counterparty risk). BIPRU 5 (Credit risk mitigation) also contains material applicable to the IRB approach.
Overview
The IRB approach is an alternative to the standardised approach for calculating a firm's credit risk capital requirements. It may be applied to all a firm's exposures or to some of them, subject to various limitations on partial use as set out in BIPRU 4.2. Under the IRB approach capital requirements are based on a firm's own estimates of certain parameters together with other parameters set out in the Banking Consolidation Directive.
Exposures are divided into a number of distinct exposure classes. These are listed in BIPRU 4.3.2 R. There is a special treatment for purchased receivables, although they do not form an exposure class on their own.
For exposures in the sovereign, institution and corporate IRB exposure class, there is a foundation IRB approach under which a firm provides its own estimates of PD and an advanced IRB approach under which a firm additionally provides its own estimates of LGD and conversion factors. The distinction between the foundation IRB approach and the advanced IRB approach only applies to this IRB exposure class.
For retail exposures, a firm provides its own estimates of PD, LGD and conversion factors.
For the corporate exposure class there is a separate sub-class of specialised lending exposure. A firm may calculate risk weights for these exposures, where it is able to do so, in the same way as it does for the rest of its corporate exposure class, i.e. using the foundation IRB approach or the advanced IRB approach. Where a firm is not able to use this approach it may calculate risk weights for specialised lending exposures by slotting them into predetermined risk weights.
For equity exposures there are two approaches based on market based measures and a third under which a firm uses its own estimates of PD only.
IRB permissions: general
The rules in GENPRU and BIPRU do not allow a firm to use the IRB approach. A firm that wishes to use the IRB approach should therefore apply for permission to use the IRB approach using the application procedure explained in BIPRU 1.3. If a firm's application is granted, its terms will be set out in an IRB permission.
The FSA recognises that the nature of IRB approaches will vary between firms. The scope of and the requirements and conditions set out in an IRB permission may therefore differ in substance or detail from BIPRU 4 in order to address individual circumstances adequately. However any differences will only be allowed if they are compliant with the Banking Consolidation Directive. An IRB permission will implement any such variation by modifying the relevant provisions of GENPRU and BIPRU. An IRB permission may also include additional conditions to meet the particular circumstances of the firm.
- (1)
The FSA will only grant an IRB permission if it is satisfied that the firm's systems for the management and rating of credit risk exposures are sound and implemented with integrity and, in particular, that they meet the standards in BIPRU 4.2.2 R in accordance with the minimum IRB standards.
- (2)
Under BIPRU 4.2.11 R, a firm applying for an IRB permission is required to demonstrate that it has been using for the IRB exposure classes in question rating systems that were broadly in line with the minimum IRB standards for internal risk measurement and management purposes for at least three years prior to the date of its IRB permission.
- (3)
Under BIPRU 4.2.13 R, a firm applying for the use of own estimates of LGDs and/or conversion factors should demonstrate that it has been estimating and employing own estimates of LGDs and/or conversion factors in a manner that was broadly consistent with the minimum IRB standards for use of own estimates for at least three years prior to the date of its IRB permission or of a variation of its IRB permission that, in either case, entitles the firm to use own estimates of LGDs and/or conversion factors.
Link to standard rules: Incorporation of the IRB output into the capital calculation
An IRB permission will modify GENPRU 2.1.51 R (Calculation of the credit risk capital requirement) by amending, to the extent set out in the IRB permission, the calculation of the credit risk capital requirement in accordance with BIPRU 4 and the other provisions of the Handbook relating to the IRB approach.
A firm must calculate its credit risk capital component as the sum of:
- (1)
(for exposures to which the standardised approach is applied) the credit risk capital component as calculated under BIPRU 3.1.5 R; and
- (2)
(for exposures to which the IRB approach is applied to which the standardised approach would otherwise apply in accordance with BIPRU 3.1.5 R (Credit risk capital component)), 8% of the total of the firm's risk weighted exposure amounts calculated in accordance with the IRB approach.
For exposures covered by an IRB permission, BIPRU 5 (Credit risk mitigation) is modified by BIPRU 4.10.
Under BIPRU 4.9, a firm is required to deal with securitisation positions under those provisions of BIPRU 9 applicable to a firm using the IRB approach.
Exposures treated under BIPRU 13 are required to be dealt with in accordance with the IRB approach to the extent set out in BIPRU 13.
By modifying GENPRU 2.1.51 R to allow the firm to use the IRB approach to calculate all or part of its risk weighted exposure amounts, the FSA is treating it like an application rule. The modification means that the provisions of BIPRU relating to the IRB approach supersede the rules relating to the standardised approach for exposures coming within the scope of the IRB permission.
A reference in the Handbook to a provision of the IRB approach, in the case of a firm:
- (1)
excludes any provision of the IRB approach set out in the Handbook that is not applied to that firm by its IRB permission;
- (2)
includes any additional provision contained in the firm's IRB permission; and
- (3)
takes into account any other amendments made to the provisions in the Handbook relating to the IRB approach made by the firm's IRB permission.
To the extent that a firm's IRB permission does not allow it to use a particular approach in the Handbook relating to the IRB approach the Handbook provision in question does not apply to the firm.
If a provision of the Handbook relating to the IRB approach says that a firm may do something if its IRB permission allows it, a firm may do that thing unless its IRB permission expressly says that it may not do so except that:
- (1)
BIPRU 4.2.18 R - BIPRU 4.2.19 R (Sequential implementation of IRB approach) and BIPRU 4.2.26 R (1)-BIPRU 4.2.26R (5) (Combined use of standardised approach with IRB approach) only apply if expressly permitted by a firm's IRB permission;
- (2)
a firm may not use the advanced IRB approach for the sovereign, institution and corporate IRB exposure class except to the extent expressly permitted by the firm's IRB permission;
- (3)
if a firm uses its own estimates of LGD and conversion factors it may only take into account unfunded credit protection to reduce LGD in the manner set out in its IRB permission;
- (4)
if a firm uses its own estimates of LGD and conversion factors it may only recognise the effects of financial collateral under BIPRU 10.6.17 R (Exemptions for firms using own estimates of LGD and conversion factors under the IRB approach)4 in the manner set out in its IRB permission;
- (5)
a firm must deal with equity exposures in the manner set out in its IRB permission; and
- (6)
(in the case of collateral that is only eligible for recognition under paragraph 21 of Part 1 of Annex VIII of the Banking Consolidation Directive (Other physical collateral)) a firm may not recognise as eligible collateral an item of a type referred to in BIPRU 4.10.16 R (Other physical collateral) unless that item is of a type specified as permitted in its IRB permission.
An IRB permission will set out firm-specific material. This will generally include:
- (1)
details about the firm's methodology for carrying out the IRB approach, including the models and rating systems that a firm should use;
- (2)
reporting requirements; and
- (3)
requirements about internal control structure.
Compliance
If a firm ceases to comply with the requirements of the IRB approach, it must either present to the FSA a plan for a timely return to compliance or demonstrate that the effect of non-compliance is immaterial.
[Note: BCD Article 84(5)]
If a firm ceases to comply with the requirements of the IRB approach, the FSA may revoke the IRB permission or take other appropriate supervisory action.
For the purposes of BIPRU 4.1.25 R, the FSA will expect a firm to demonstrate that, taking into account all instances where the firm has not complied with the requirements of the IRB approach, the effect of non-compliance is immaterial.