Internal Ratings-Based Approach (IRB)

The internal ratings-based (IRB) approach is a method under the Basel framework by which a bank, with its supervisor's approval, calculates the capital it must hold against credit risk using its own estimates of risk for each borrower and exposure. Those estimates are fed into formulas set by regulators to produce risk-weighted assets, on which minimum capital ratios are based. The alternative is the standardised approach for credit risk, in which risk weights are prescribed by regulation.

The approach was introduced by the Basel Committee on Banking Supervision in the Basel II framework of 2004. The intention was to make capital more sensitive to actual risk and to reward banks for better risk measurement. Experience after the 2008 crisis showed wide and unexplained differences in the risk weights that banks assigned to similar exposures, and the final Basel III reforms of 2017 restricted its use.

The approach rests on four inputs for each exposure.

• Probability of default. The likelihood that the borrower defaults within one year.
• Loss given default. The share of the exposure the bank expects to lose if default occurs, after recoveries.
• Exposure at default. The amount expected to be outstanding at the time of default, including drawings on undrawn commitments.
• Effective maturity. The remaining economic life of the exposure.

From these, expected loss is the product of the first three:

Capital is held against unexpected loss. A supervisory formula converts the inputs into a capital requirement $K$ per unit of exposure, and risk-weighted assets are then:

The factor of 12.5 is the reciprocal of the 8 per cent minimum capital ratio. The formula for $K$ is derived from a model with a single systematic risk factor and is calibrated to a 99.9 per cent confidence level over one year. It includes an asset correlation that depends on the asset class and, for corporate exposures, on the probability of default.

There are two versions for corporate, sovereign and bank exposures. Under the foundation approach, the bank estimates the probability of default and uses values set by supervisors for the other inputs. Under the advanced approach, the bank also estimates loss given default, exposure at default and maturity. For retail exposures, such as mortgages, credit cards and consumer loans, there is a single approach in which the bank estimates all inputs for pools of similar loans.

A bank must satisfy its supervisor that its rating system is sound and is used in running the business, a condition known as the use test: internal ratings must play a real part in credit approval, pricing, limits and reporting, not only in capital calculation. Rating systems must distinguish risk meaningfully across a sufficient number of grades, be based on several years of data, cover a full economic cycle, and be validated independently of the staff who build them. Estimates of loss given default must reflect downturn conditions. Performance is checked by backtesting estimates against outcomes, and supervisors review models both at approval and periodically afterwards.

The approach also compares expected loss with accounting provisions. A shortfall of provisions is deducted from Common Equity Tier 1 capital; an excess may be counted in Tier 2 capital up to a limit.

The reforms agreed in December 2017 aimed to reduce unwarranted variation in risk weights.

• Narrower scope. The advanced approach is no longer available for exposures to banks and other financial institutions or to large corporates, for which only the foundation approach or the standardised approach may be used. The IRB approach is removed altogether for equity exposures.
• Input floors. Minimum values apply to bank-estimated parameters, including a floor on the probability of default.
• Output floor. A bank's total risk-weighted assets calculated with internal models may not fall below 72.5 per cent of the amount calculated under standardised approaches, phased in over several years.
• Scaling factor. The multiplier of 1.06 previously applied to IRB risk-weighted assets was removed.

Implementation varies. The European Union has applied its version from January 2025, with the output floor phased in, and the United Kingdom has set a start date of January 2027. In the United States, proposals published in 2023 to end the use of internal models for credit risk capital were not finalised; a revised proposal issued in March 2026 would likewise replace the internal models-based approach with a standardised one for the largest banks.

Supporters argue that the approach aligns capital with risk and encourages investment in data and risk management, and that standardised weights are too crude for low-risk portfolios such as prime mortgages. Critics point to complexity, to the incentive for banks to choose assumptions that lower capital, to the difficulty of estimating parameters for portfolios with few defaults, and to procyclicality, since estimated default probabilities rise in downturns and increase capital requirements when capital is hardest to raise. Supervisory exercises in Europe, including a multi-year review of internal models by the European Central Bank, found many deficiencies and led to increases in risk weights. The output floor is the regulators' compromise: models are retained, but their benefit is capped. IRB results feed into the Pillar 1 capital requirement and are published in Pillar 3 disclosures.

• Basel Committee on Banking Supervision
• European Banking Authority