The Internal Rating-Based Approach (IRB Approach) is a widely used method for assessing credit risks applied in banking regulation and risk management. The IRB Approach allows banks and financial institutions to evaluate the creditworthiness of their customers and the associated credit risks more accurately.
Under the IRB Approach, banks utilize their own internal assessment models and systems to quantify the credit risk for individual borrowers or credit portfolios. This enables a more individualized and precise assessment of credit risks compared to standardized approaches.
The IRB Approach classifies borrowers into different classes or groups based on their expected default risk. This classification assists banks in determining adequate capital buffers for potential credit defaults. The higher the risk of a borrower or a credit position, the more equity capital the bank must hold for protection.
The introduction of the IRB Approach was part of the Basel II agreements and has been further developed in the Capital Requirements Regulation (CRR) and Basel III. This approach allows for a differentiated assessment of credit risks and aims to enhance the risk assessment and risk management capabilities of banks.
It's important to note that the application of the IRB Approach is subject to approval and supervision by regulatory authorities to ensure that banks use appropriate and consistent assessment methods and maintain sufficient equity capital buffers to cover credit risks.
