Under this approach the banks are allowed to develop their own empirical model to quantify required capital for credit risk. Banks can use this approach only subject to approval from their local regulators.
Some formulae in internal-ratings-based approach[edit]
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 )
AVC[2] (Asset Value Correlation) was introduced by the Basel III Framework, and is applied as following:
if the company is a large regulated financial institution (total asset equal or greater to US $100 billion) or an unregulated financial institution regardless of size
http://www.bis.org/publ/bcbs107.htm Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework (BCBS)
http://www.bis.org/publ/bcbs118.htm Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework (BCBS) (November 2005 Revision)
http://www.bis.org/publ/bcbs128.pdf Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework, Comprehensive Version (BCBS) (June 2006 Revision)
http://www.bis.org/publ/bcbs189.pdf Basel III: A global regulatory framework for more resilient banks and banking systems (BCBS) (June 2011 Revision)