Basel III Credit Risk Modeling: IRB Approach, Standardized Approach & Output Floor

Under the standardized approach (SA), institutions use supervisory risk weights per exposure class. For example, 20% for well-rated banks or 75% for retail exposures. Under the IRB approach, institutions estimate their own risk parameters: Foundation IRB (F-IRB) covers only probability of default (PD), while Advanced IRB (A-IRB) also includes LGD and EAD. The IRB approach requires supervisory approval and comprehensive model validation per EBA guidelines.

PD (Probability of Default) is the estimated likelihood of a borrower defaulting within one year. LGD (Loss Given Default) is the loss rate upon default, the share of the exposure not recovered (1 minus recovery rate). EAD (Exposure at Default) is the expected exposure amount at the time of default. Expected loss is calculated as: EL = PD x LGD x EAD.

The output floor limits capital relief from internal models: risk-weighted assets (RWA) under the IRB approach must not fall below a set percentage of RWA under the standardized approach. Starting January 2025 at 50%, the floor rises to 72.5% by 2030. For institutions with low IRB RWA, this means higher capital requirements, triggering a strategic reassessment of IRB versus SA.

CRR III (EU Regulation 2024/1623, applicable from January 2025) introduces key changes: the output floor (phasing to 72.5%), LGD input floors (e.g., 25% for unsecured senior corporate exposures), restrictions on A-IRB for certain exposure classes (large corporates, banks, and insurers must use F-IRB or SA), more risk-sensitive SA risk weights, and revised exposure classes.

Model validation assesses discrimination power, calibration, and stability of PD/LGD/EAD models per EBA guidelines (EBA/GL/2017/16). Key tools include Gini coefficient and ROC curve for discrimination, binomial and Hosmer-Lemeshow tests for calibration, and population stability indices for temporal stability. Validation must be performed annually by an independent unit and is reviewed by supervisors during the SREP process.

Input floors are minimum thresholds for internally estimated LGD values under A-IRB. CRR III prescribes: 25% LGD for unsecured senior corporate and bank exposures, 0% for exposures fully collateralized by financial instruments (with appropriate haircuts), and differentiated floors for real estate collateral. These floors prevent unrealistically low loss estimates and ensure minimum capital coverage.

The IRB approach is advantageous for large portfolios with strong data quality and low historical default rates, where internal PD estimates can be significantly below the blanket SA risk weights. However, the output floor (72.5% from 2030) narrows this capital benefit. A strategic analysis must weigh implementation costs, regulatory requirements, and the remaining RWA advantage per exposure class.

ADVISORI supports institutions across the full chain: from developing and calibrating PD/LGD/EAD models through EBA-compliant model validation to strategic capital planning under CRR III. We analyze output floor impacts on your portfolio, evaluate the optimal modeling strategy (F-IRB vs. A-IRB vs. SA), and assist with stress testing, ICAAP capital planning, and supervisory approval processes.