Some credit assessments in standardised approach refer to unrated assessment. Basel II also encourages banks to initiate internal ratings-based approach for measuring credit risks. Banks are expected to be more capable of adopting more sophisticated techniques in credit risk management.
Banks can determine their own estimation for some components of risk measure: the probability of default (PD), loss given default (LGD), exposure at default (EAD) and effective maturity (M). For public companies, default probabilities are commonly estimated using either the "structural model" of credit risk proposed by Robert Merton (1974) or reduced form models like the Jarrow–Turnbull model. For retail and unlisted company exposures, default probabilities are estimated using credit scoring or logistic regression, both of which are closely linked to the reduced form approach.
The goal is to define risk weights by determining the cut-off points between and within areas of the expected loss (EL) and the unexpected loss (UL), where the regulatory capital should be held, in the probability of default. Then, the risk weights for individual exposures are calculated based on the function provided by Basel II.
Below are the formulae for some banks' major products: corporate, small-medium enterprise (SME), residential mortgage and qualifying revolving retail exposure. S being Min(Max(Sales Turnover,5),50 )
In the formulas below,
Corporate exposure adjustment for SME
For small and medium enterprises with annual Sales Turnover below 50 million euro, the correlation may be adjusted as follows:[3]
Correlation
In the above formula, S is the enterprise's annual sales turnover in millions of euro.
Other retail exposure
All other retail exposures are calculated as follows:[6]
Correlation
Capital Requirement
Risk-weighted assets