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BIPRU 4.2 The IRB approach: High level material

Application

BIPRU 4.2.1R

This section applies to all exposures treated under the IRB approach.

General approach to granting an IRB permission

BIPRU 4.2.2R

A firm's systems for the management and rating of credit risk exposures must be sound and implemented with integrity and, in particular, they must meet the following standards in accordance with the minimum IRB standards:

  1. (1)

    the firm's rating systems provide for a meaningful assessment of obligor and transaction characteristics, a meaningful differentiation of risk and accurate and consistent quantitative estimates of risk;

  2. (2)

    internal ratings and default and loss estimates used in the calculation of capital requirements and associated systems and processes play an essential role in the risk management and decision-making process, and in the credit approval, internal capital allocation and corporate governance functions of the firm;

  3. (3)

    the firm has a credit risk control unit responsible for its rating systems that is appropriately independent and free from undue influence;

  4. (4)

    the firm collects and stores all relevant data to provide effective support to its credit risk measurement and management process; and

  5. (5)

    the firm documents its rating systems, the rationale for their design and validates its rating systems.

[Note: BCD Article 84(2) (part)]

BIPRU 4.2.3R

Where an EEA parent institution3 and its subsidiary undertakings or an EEA parent financial holding company3 and its subsidiary undertakings or an EEA parent mixed financial holding company and its subsidiary undertakings6 use the IRB approach on a unified basis, the question whether the minimum IRB standards are met is answered by considering the parent undertaking and its subsidiary undertakings together,6 unless the firm's IRB permission specifies otherwise.

[Note: BCD Article 84(2) (part)]

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Outsourcing

BIPRU 4.2.4G
  1. (1)

    This guidance sets out the basis on which a firm may rely upon a rating system or data provided by another member of its group.

  2. (2)

    A firm may rely upon a rating system or data provided by another member of its group if the following conditions are satisfied:

    1. (a)

      the firm only does so to the extent that it is appropriate, given the nature and scale of the firm's business and portfolios and the firm's position within the group;

    2. (b)

      the group is an EEA banking and investment group;

    3. (c)

      the integrity of the firm's systems and controls is not adversely affected;

    4. (d)

      the outsourcing of these functions meets the requirements of SYSC; and

    5. (e)

      (if the provision of the rating system or data is not carried out in the United Kingdom or in the jurisdiction of the competent authority that is the lead regulator of the group) the firm can demonstrate to the appropriate regulator that the ability of the appropriate regulator and that lead regulator to carry out their responsibilities under the Handbook, the Banking Consolidation Directive and the Capital Adequacy Directive are not adversely affected.

  3. (3)

    If a firm does use a rating system or data provided by another member of its group, the requirements in BIPRU 4 continue to apply to that firm in respect of that rating system and data. A firm cannot absolve itself of the responsibility for complying with those requirements by claiming that any breach is caused by the actions of a third party to which the firm has delegated tasks. The rating system and data provision are still those of the firm, even though personnel elsewhere in the firm's group are carrying out these functions on its behalf. So any references in BIPRU to what a firm, its personnel and its management should and should not do still apply.

  4. (4)

    If a firm does use a rating system or data provided by another group member, the firm's governing body should formally delegate those functions to the persons or bodies that are to carry them out.

  5. (5)

    Before delegating the provision of a rating system or data to another group member, the firm's governing body should have explicitly considered the arrangement and decided that it is appropriate and that it enables the firm to meet the conditions in (2).

Assessment and estimation

BIPRU 4.2.5G
  1. (1)

    This paragraph provides guidance on BIPRU 4.2.2 R and in particular BIPRU 4.2.2 R (1).

  2. (2)

    The information that a firm produces or uses for the purpose of the IRB approach should be reliable and take proper account of the different users of the information produced (customers, shareholders, regulators and other market participants).

  3. (3)

    A firm should establish quantified and documented targets and standards, against which it should test the accuracy of data used in its rating systems.

  4. (4)

    Tests under (3) might include:

    1. (a)

      report and accounts reconciliation, including completeness in relation to (b);

    2. (b)

      whether every exposure has a PD, LGD and, if applicable, conversion factor for reporting purposes;

    3. (c)

      whether the firm's risk control environment has key risk indicators for the purpose of monitoring and ensuring data accuracy;

    4. (d)

      whether the firm has an adequate business and information technology infrastructure with fully documented processes;

    5. (e)

      whether the firm has clear and documented standards on ownership of data (including inputs and manipulation) and timeliness of current data (daily, monthly, real time); and

    6. (f)

      whether the firm has a comprehensive quantitative audit programme.

  5. (5)

    The reconciliation referred to in 4(a) should be reasonably fit for purpose. In particular it should meet the standards in (6) and (7).

  6. (6)

    For data inputs, testing for accuracy of data, including the reconciliation referred to in 4(a), should be sufficiently detailed so that, together with other available evidence, it gives reasonable assurance that data input into the rating system is accurate, complete and appropriate. Input data fails the required standard if it gives rise to a serious risk of material misstatement in the capital requirement either immediately or subsequently.

  7. (7)

    For data outputs, the firm, as part of the reconciliation referred to in 4(a), should be able to identify and explain material differences between the outputs produced under accounting standards and those produced under the requirements of the IRB approach, including in relation to areas that address similar concepts in different ways (for example expected loss on the one hand and accounting provisions on the other).

  8. (8)

    A firm should have clear and documented standards and policies about the use of data in practice (including information technology standards) which should in particular cover the firm's approach to the following:

    1. (a)

      data access and security;

    2. (b)

      data integrity, including the accuracy, completeness, appropriateness and testing of data; and

    3. (c)

      data availability.

Further requirements concerning the use test

BIPRU 4.2.6R

If a firm uses separate models for the purpose of the IRB approach and for its internal purposes as referred to in BIPRU 4.2.2 R (2) it must be able to demonstrate the reasonableness of any differences between those models.

BIPRU 4.2.7G
  1. (1)

    This paragraph provides guidance on BIPRU 4.2.2 R and in particular BIPRU 4.2.2 R (2).

  2. (2)

    The IRB approach as applicable to a firm should be an integral part of its business and risk management processes and procedures to the extent that credit risk is relevant to them. It should also have a substantial influence on its decision-making and actions.21

    1. (a)

      particular regard should be had to the use of the IRB approach in:

      1. (i)

        credit approval;

      2. (ii)

        individual and portfolio limit setting;

      3. (iii)

        reporting of credit risk information; and

      4. (iv)

        provisioning;21

    2. (b)

      other relevant aspects include:

      1. (i) 2

        assessment of economic capital;

      2. (ii)

        2internal capital allocation so far as related to credit risk;

      3. (iii)

        2risk appetite;

      4. (iv)

        2strategy and acquisitions;

      5. (v)

        2profitability and performance; and

      6. (vi)

        2performance-related remuneration;

    3. (c)

      the carrying out of the firm's obligations under the overall Pillar 2 rule; and

    4. (d)

      matters relating to the firm's infrastructure, including information technology, skills and resources and organisational culture.

BIPRU 4.2.8G

This paragraph provides further guidance on BIPRU 4.2.2 R and in particular BIPRU 4.2.2 R (2). In the appropriate regulator's view risk management has an essential role in informing risk decisions. However, an essential role does not necessarily mean an exclusive role or even always a primary role. There may be justifiable differences between the IRB approach and the firm's use of rating systems for its internal purposes as referred to in BIPRU 4.2.2 R (2). For example, internal standards and policies may refer to estimates of PD and LGD for the length of the asset rather than to estimates based on a one-year period (in the case of PD estimates) or on an economic downturn (in the case of LGD estimates) required by the IRB approach.

BIPRU 4.2.9G

If a firm uses scorecards for its internal credit approval process and the models it uses for the purpose of the IRB approach are fundamentally different from those scorecards, a firm's demonstration of how this is compatible with BIPRU 4.2.2 R (2) might include demonstrating that estimates calculated under the IRB approach are used to change sanctioning decisions at an individual or portfolio level. Examples of this might include amending cut-offs, the application of policy rules, the revision of an existing scorecard or the introduction of a new one or taking strategic decisions on which segments of the market to target.

BIPRU 4.2.10G

To the extent that a firm uses LGD estimates in its internal risk management processes that differ from the downturn LGDs used in the calculation of risk weighted assets3 (see BIPRU 4.3.103 R), the reasons for the difference should be documented in accordance with BIPRU 4.3.109 R.

Requirements concerning the experience requirement

BIPRU 4.2.11R

A firm must be able to demonstrate that it has been using for the IRB exposure classes in question rating systems that were broadly in line with the minimum IRB standards for internal risk measurement and management purposes for at least three years prior to the date of its IRB permission.

[Note: BCD Article 84(3)]

BIPRU 4.2.12G

In meeting the experience requirement under BIPRU 4.2.11 R, the appropriate regulator would expect a firm to be able to demonstrate that it has been:

  1. (1)

    operating an internal rating system with estimates of PD;

  2. (2)

    meeting the standards in BIPRU 4 for senior management knowledge and reporting; and

  3. (3)

    meeting the standards in BIPRU 4 relating to the use of rating systems in its business;

for the required minimum 3 year period.

BIPRU 4.2.13R

A firm that has applied for the use of own estimates of LGDs and/or conversion factors must be able to demonstrate to the appropriate regulator that it has been estimating and employing own estimates of LGDs and/or conversion factors in a manner that was broadly consistent with the minimum IRB standards for use of own estimates of those parameters for at least three years prior to the date of its IRB permission or of a variation of its IRB permission that, in either case, entitled the firm to use own estimates of LGDs and/or conversion factors.

[Note: BCD Article 84(4)]

BIPRU 4.2.14G

In meeting the experience requirement under BIPRU 4.2.13 R, the appropriate regulator would expect a firm to be able to demonstrate that it has been:

  1. (1)

    operating an internal rating system with estimates of LGD and with conversion factors; and

  2. (2)

    compliant with BIPRU 4.2.11 R as applied to the advanced IRB approach.

for the required minimum 3 year period.

BIPRU 4.2.15G

In the appropriate regulator's view the standard required by BIPRU 4.2.11 R and BIPRU 4.2.13 R is for a rating system to be improved in the light of experience during the three year period so that it meets the minimum requirements more fully for the last year than for the two prior years, provided that the rating system has not changed so profoundly that experience from the first or second years becomes of marginal relevance in assessing the reliability of the changed rating system.

Implementation of the internal ratings based approach

BIPRU 4.2.16R

A firm must comply with any requirements in its IRB permission relating to the matters described in BIPRU 4.2.17 R - BIPRU 4.2.35 G.

BIPRU 4.2.17R

Without prejudice to BIPRU 4.2.26 R, a firm and any parent undertaking and its subsidiary undertakings must implement the IRB approach for all exposures.

[Note: BCD Article 85(1) (part)]

BIPRU 4.2.18R

To the extent that a firm's IRB permission permits this, implementation may be carried out sequentially across the different IRB exposure classes within the same business unit, across different business units in the same group or for the use of own estimates of LGDs or conversion factors for the calculation of risk weights for the sovereign, institution and corporate IRB exposure class.3

[Note: BCD Article 85(1) (part)]

BIPRU 4.2.19R

In the case of the retail exposures, implementation may (but only to the extent provided for in the firm's IRB permission) be carried out sequentially across the categories of exposures to which the different correlations in BIPRU 4.6.41 R-BIPRU 4.6.44 R correspond.

[Note: BCD Article 85(1) (part)]

BIPRU 4.2.20R
  1. (1)

    Implementation of the IRB approach as referred to in BIPRU 4.2.18 R must be carried out within a reasonable period of time as set out in the IRB permission.

  2. (2)

    The implementation must be carried out subject to strict conditions determined by the appropriate regulator and set out in the IRB permission.

  3. (3)

    A firm must not use the flexibility under BIPRU 4.2.18 R selectively with the purpose of achieving reduced minimum capital requirements in respect of those IRB exposure classes or business units that are yet to be included in the IRB approach or in the use of own estimates of LGDs and conversion factors.

[Note: BCD Article 85(2)]

BIPRU 4.2.21G
  1. (1)

    A firm should achieve full roll-out of the IRB approach to all its exposures, subject to the exemptions outlined in BIPRU 4.2.26 R, within the period specified in its IRB permission. A firm should not retain a permanent mix of portfolios on the standardised approach and the IRB approach, on the foundation IRB approach and the advanced IRB approach or on a mixture of all approaches with the exception of portfolios covered by those exemptions.

  2. (2)

    This applies to a move:

    1. (a)

      from the standardised approach to the IRB approach;

    2. (b)

      from the foundation IRB approach to the advanced IRB approach; and

    3. (c)

      from the transitional rules and guidance for BIPRU to the IRB approach.

  3. (3)

    The period referred to in BIPRU 4.2.20 R (1) will generally be not more than three years of starting use of the IRB approach or the advanced IRB approach as applicable.

BIPRU 4.2.22R

A firm using the IRB approach for any IRB exposure class must at the same time use the IRB approach for the equity exposure class.

[Note: BCD Article 85(3)]

BIPRU 4.2.23R

Subject to BIPRU 4.2.17 R - BIPRU 4.2.20 R, BIPRU 4.2.22 R and BIPRU 4.2.26 R, a firm that has an IRB permission must not use the standardised approach for the calculation of risk weighted exposure amounts for the exposures to which the IRB approach applies under the IRB permission.

[Note: BCD Article 85(4)]1

BIPRU 4.2.24R

Subject to BIPRU 4.2.17 R - BIPRU 4.2.22 R and BIPRU 4.2.26 R, a firm whose IRB permission provides for the use of the advanced IRB approach for the calculation of LGDs and conversion factors for the sovereign, institution and corporate IRB exposure class must not use the LGD values and conversion factors applicable to the foundation IRB approach for the exposures to which the advanced IRB approach applies under the IRB permission.

[Note: BCD Article 85(5)]

BIPRU 4.2.25G

The appropriate regulator will not agree to a firm's request to revoke or vary its IRB permission so as to permit the firm to revert to the standardised approach except for demonstrated good cause. Likewise, the appropriate regulator will not agree to a firm's request to revoke or vary its IRB permission so as to permit the firm to revert to the foundation IRB approach if the IRB permission provides for it to use the advanced IRB approach, except for demonstrated good cause.

Combined use of methodologies: Basic provisions

BIPRU 4.2.26R
  1. (1)

    To the extent that its IRB permission permits this, a firm permitted to use the IRB approach in the calculation of risk weighted exposure amounts and expected loss amounts3 for one or more IRB exposure classes may apply the standardised approach in accordance with this rule.

    3
  2. (2)

    A firm may apply the standardised approach to the IRB exposure class referred to in BIPRU 4.3.2 R (1) (Sovereigns) where the number of material counterparties is limited and it would be unduly burdensome for the firm to implement a rating system for these counterparties. A firm may include in this treatment an exposure of the type described in BIPRU 3.4.18 R (Exposures to churches or religious communities) that would fall within BIPRU 3.4.15 R or BIPRU 3.4.17 R (Exposure to a regional government or local authority) if those provisions had not been excluded by BIPRU 3.4.18 R.

  3. (3)

    A firm may apply the standardised approach to the IRB exposure class referred to in BIPRU 4.3.2 R (2) (Institutions), where the number of material counterparties is limited and it would be unduly burdensome for the firm to implement a rating system for these counterparties.

  4. (4)

    A firm may apply the standardised approach to exposures in non-significant business units as well as IRB exposure classes that are immaterial in terms of size and perceived risk profile.

  5. (5)

    A firm may apply the standardised approach to exposures to the central governments4 of EEA States and their4 regional governments, local authorities and administrative bodies, provided that:

    44
    1. (a)

      there is no difference in risk between the exposures to the central government and those other exposures because of specific public arrangements; and

    2. (b)

      exposures to the central government are assigned a 0% risk weight under the standardised approach.

  6. (6)

    A firm may apply the standardised approach to exposures of a firm to a counterparty which is its parent undertaking, its subsidiary undertaking or a subsidiary undertaking of its parent undertaking provided that the counterparty is an institution, a financial holding company, a mixed financial holding company,6 a financial institution, an asset management company or an ancillary services undertaking subject to appropriate prudential requirements.

  7. (7)

    A firm may apply the standardised approach to equity exposures to entities whose credit obligations qualify for a 0% risk weight under the standardised approach (including those publicly sponsored entities where a zero risk weight can be applied).

  8. (8)

    A firm may apply the standardised approach to equity exposures incurred under legislative programmes to promote specified sectors of the economy that provide significant subsidies for the investment to the firm and involve some form of government oversight and restrictions on the equity investments. This exclusion is limited to an aggregate of 10% of capital resources.

  9. (9)

    A firm may apply the standardised approach to the exposures identified in BIPRU 3.4.48 R (Exposures in the form of minimum reserves required by the European Central Bank or by the central bank of an EEA State) meeting the conditions specified therein.

  10. (10)

    A firm may apply the standardised approach to state and state-reinsured guarantees pursuant to BIPRU 5.7.12 R (Conditions for state and state-reinsured guarantees).

[Note: BCD Article 89(1)]

Combined use of methodologies: Documentation

BIPRU 4.2.27G

As part of the application for an IRB permission, a firm should have a well documented policy explaining the basis on which exposures are to be selected for permanent exemption from the IRB approach and for treatment under the standardised approach. The firm's roll out plan should also contain provisions for the continuing application of that policy on a consistent basis over time.

Combined use of methodologies: Sovereign and institutional, exposures

BIPRU 4.2.28G

A firm intending to make use of BIPRU 4.2.26 R (2) or BIPRU 4.2.26 R (3) should demonstrate to the appropriate regulator when applying for an IRB permission that it meets the requirements of those provisions with respect to its sovereign or, as the case may be, institutional, exposures.

Combined use of methodologies: Meaning of non-significance and immateriality

BIPRU 4.2.29R

For the purposes of BIPRU 4.2.26 R (4), the equity exposure IRB exposure class of a firm must be considered material if its aggregate value, excluding equity exposures incurred under legislative programmes as referred to in BIPRU 4.2.26 R (8) but including exposures in a CIU treated as equity exposures in accordance with BIPRU 4.9.11 R to BIPRU 4.9.15 R,4 exceeds, on average over the preceding year, 10% of the firm's capital resources. If the number of those equity exposures is less than 10 individual holdings, that threshold is 5% of the firm's capital resources.

[Note: BCD Article 89(2)]

4
BIPRU 4.2.30R
  1. (1)

    This rule sets out what must be treated as being non-significant business or immaterial for the purposes of BIPRU 4.2.26 R (4), for exposures that do not fall within the equity exposure IRB exposure class.

  2. (2)

    A firm may elect permanently to exclude exposures from the IRB approach and apply the standardised approach. However a firm may only make use of this exemption to the extent that:

    1. (a)

      the consolidated credit risk requirement (adjusted under (6)) so far as it is attributable to the excluded exposures;

    would be no more than 15% of:

    1. (b)

      the consolidated credit risk requirement (adjusted under (6)) with respect to all exposures (including the ones dealt with under (a)).

  3. (3)

    Exposures excluded under BIPRU 4.2.29 R or BIPRU 4.2.26 R (2), BIPRU 4.2.26 R (3) and BIPRU 4.2.26 R (5)-BIPRU 4.2.26 R (7) must not be included in (a) or (b).

  4. (4)

    The calculation in (2)(a) is based on the standardised approach.

  5. (5)

    The calculation in (2)(b) is based on whichever of the standardised approach and the IRB approach would apply to the exposures referred to in (2)(b) at the time when the calculation is being made.

  6. (6)

    The consolidated credit risk requirement is adjusted for the purposes of this rule as follows:

    1. (a)

      the element based on the concentration risk capital component is excluded, with only the elements based on the credit risk capital component and the counterparty risk capital component being taken into account; and

    2. (b)

      the calculation is carried out with respect to the group of undertakings referred to in BIPRU 4.2.17 R.

  7. (7)

    If a group with respect to which the calculation in this rule is being carried out is not required to calculate the consolidated credit risk requirement, the calculations in this rule must be carried out as if it were.

BIPRU 4.2.31R

If a firm applies to use the advanced IRB approach for the sovereign, institution and corporate IRB exposure class, BIPRU 4.2.26 R (4) also applies with respect to exposures in that class. For these purposes, to the extent permitted in the firm's IRB permission, a firm may:

  1. (1)

    exclude some exposures from the IRB approach and apply the standardised approach to those exposures; and

  2. (2)

    exclude other exposures from the advanced IRB approach and apply the foundation IRB approach to those exposures.

BIPRU 4.2.32G

Where BIPRU 4.2.31 R applies:

  1. (1)

    the 15% limit in BIPRU 4.2.30 R (2) is a combined limit for excluded exposures remaining on the standardised approach and excluded exposures remaining on the foundation IRB approach; and

  2. (2)

    the calculation in BIPRU 4.2.30 R (2)(a) is carried out under whichever method of calculation would be applicable to the exposure in question.

Combined use of methodologies: Territorial aspects

BIPRU 4.2.33G
  1. (1)

    7[deleted]

  2. (2)

    7[deleted]

  3. (3)

    7[deleted]

  4. (4)

    7[deleted]

    7
  5. (5)

    7[deleted]

  6. (6)

    7[deleted]

Combined use of methodologies: Intra-group exposures

BIPRU 4.2.34G
  1. (1)

    Generally, the appropriate regulator will consider excluding, through a firm's IRB permission, exposures falling into BIPRU 4.2.26 R (6) from the IRB approach. The degree to which this exclusion applies will be set out in the firm's IRB permission.

  2. (2)

    Exposures excluded under (1) will be eligible for a 0% risk weight under the standardised approach if they satisfy the conditions in BIPRU 3.2.25 R to BIPRU 3.2.27A R5 (Zero risk weight for certain intra-group exposures).

    5
  3. (3)

    Exposures to or holdings in any non-financial undertakings in a firm's group are not eligible for permanent exemption from the IRB approach under BIPRU 4.2.26 R (6), as they are not subject to consolidated supervision. It is also the appropriate regulator's policy that exposures to or holdings in any insurance undertaking are ineligible. Such exposures should remain on the IRB approach unless excluded under another part of BIPRU 4.2.26 R.

  4. (4)

    If a firm uses the exemption in (1) it should have a policy that:

    1. (a)

      provides for the identification of connected counterparties excluded under (1);

    2. (b)

      identifies exposures that would be permanently exempted from the IRB approach under (1); and

    3. (c)

      identifies the connected counterparty exposures that are not permitted to be permanently exempted from the IRB approach under (1).

  5. (5)

    The policy in (4) should be applied consistently to all exposures excluded under (1).

Combined use of methodologies: Purchase of a new businesses

BIPRU 4.2.35G
  1. (1)

    This guidance deals with some possible effects of acquiring a major new business after the grant of an IRB permission.

  2. (2)

    A firm should if possible ensure that the exposures arising through the acquisition are dealt with in accordance with the firm's IRB permission.

  3. (3)

    If the acquisition is made during the currency of a roll out plan under BIPRU 4.2.18 R, a firm should ensure that the exposures arising through the acquisition are dealt with in accordance with that plan. For these purposes the existing and the acquired business should be considered together. The whole of the firm's business, including the newly acquired business, should be included in both the denominator and numerator of the fraction in BIPRU 4.2.30 R.

  4. (4)

    If a firm cannot comply with (2) the appropriate regulator will consider an application to vary the firm's IRB permission in order to deal with the acquisition. For example the appropriate regulator may agree to extend the time by which the roll out should be completed (see BIPRU 4.2.20 R). However any such variation should be consistent with the provisions of BIPRU 4.2 that would have applied if the acquisition had been included in the firm's original application for an IRB permission.

  5. (5)

    If the acquisition is made after a firm has completed its roll out under BIPRU 4.2.18 R the appropriate regulator will not in general agree to an application to treat an exposure:

    1. (a)

      under the standardised approach if it would otherwise be treated under the IRB approach under the firm's IRB permission; or

    2. (b)

      under the foundation IRB approach if it would otherwise be treated under the advanced IRB approach under the firm's IRB permission.

  6. (6)

    Any application to disapply the policy in (5) will be treated in accordance with the approach set out in BIPRU 4.2.25 G.

  7. (7)

    The appropriate regulator will also adopt the approach in (5) while a roll out plan is in progress if, in relation to an exposure of a particular type, the period for completion of the roll out for those exposures under that plan has ended.