IRB Approach Under Basel III: Foundation & Advanced IRB for Credit Risk

The IRB approach (Internal Ratings-Based Approach) allows institutions to use their own internal rating systems to calculate regulatory capital requirements for credit risk. Unlike the standardised approach (SA), which relies on external ratings, IRB institutions determine risk weights through borrower-specific parameters such as probability of default (PD), loss given default (LGD) and exposure at default (EAD). Use of the IRB approach requires regulatory approval.

Under Foundation IRB, the institution estimates only the probability of default (PD), while LGD, EAD and credit conversion factors are set by the regulator. Under Advanced IRB, the institution estimates all risk parameters independently: PD, LGD, EAD and conversion factors. A-IRB requires more extensive data histories and validation processes but provides more precise and often more capital-efficient risk measurement.

CRR III significantly restricts the scope of Advanced IRB: for exposures to large corporates (over EUR 500 million turnover), institutions and other financial entities, only Foundation IRB is permitted. New input floors set minimum values for PD (0.03%), LGD and conversion factors. The output floor will be phased in from 50% in 2025 to 72.5% by 2030, limiting the capital benefit from internal models compared to the standardised approach.

Using the IRB approach requires supervisory approval. Institutions must demonstrate that their internal rating systems meet the CRR minimum requirements, including sufficient data history, robust model validation, clear governance and documentation. The supervisor assesses model quality, the use test (integration into daily business) and IT infrastructure. For significant institutions in the euro area, the ECB conducts the review as part of the TRIM programme.

The output floor ensures that risk-weighted assets (RWA) calculated under the IRB approach do not fall below a certain percentage of the RWA calculated under the standardised approach. Starting at 50% in 2025 and rising to 72.5% by 2030, it effectively limits the capital savings from internal models. IRB institutions with particularly low internal RWA face higher capital requirements and must calculate the standardised approach in parallel.

The key risk parameters are: probability of default (PD), loss given default (LGD), exposure at default (EAD), credit conversion factor (CCF) and maturity (M). These parameters feed into the IRB risk weight functions to calculate the regulatory capital requirement for each exposure class. Under CRR III, minimum input floors apply to each parameter.

ADVISORI supports institutions across the full IRB lifecycle: from model development and calibration through preparation of approval documentation to ongoing validation and model governance. We assist with CRR III adaptation, output floor calculation, input floor implementation and migration from A-IRB to F-IRB for restricted exposure classes.