Standardised Approach for Credit Risk

The standardised approach for credit risk is the method in the Basel framework by which a bank calculates how much capital it must hold against the risk that borrowers and counterparties fail to pay, using risk weights prescribed by regulators. Each exposure is assigned to a class, such as sovereigns, banks, companies, retail customers or mortgages, and multiplied by the weight for that class. It is the default method for all banks and the only one used by most small and medium-sized institutions.

The alternative is the internal ratings-based approach, under which banks with supervisory approval estimate risk parameters from their own models. The standardised approach is simpler and more comparable but less sensitive to the actual risk of each borrower. It is set by the Basel Committee on Banking Supervision and written into law by each jurisdiction, in the European Union through the Capital Requirements Regulation.

The amount of each exposure, net of specific provisions, is multiplied by its risk weight to produce a risk-weighted amount. The total across all exposures is the credit risk component of the bank's risk-weighted assets:

• $\text{Exposure}_i$ is the amount of exposure $i$, after credit conversion and risk mitigation.
• $\text{Risk weight}_i$ is the percentage assigned to that exposure's class and quality.

Minimum capital is then set as a percentage of risk-weighted assets, with total capital of at least 8 per cent before buffers. A loan of 1,000,000 with a 100 per cent weight gives risk-weighted assets of 1,000,000 and a minimum total capital requirement of 80,000. The same amount lent with a 20 per cent weight gives 200,000 and 16,000. This calculation forms part of the Pillar 1 capital requirement.

Weights range from zero for the safest exposures to 150 per cent or more for the riskiest. The main drivers are:

• External ratings. For sovereigns, banks and companies, the weight depends on the credit rating given by a recognised rating agency. A highly rated sovereign carries zero and a highly rated company 20 per cent, while unrated companies generally carry 100 per cent.
• Retail exposures. Qualifying loans to individuals and small businesses in a diversified portfolio receive 75 per cent.
• Real estate. Loans secured on property receive lower weights. Under the revised framework the weight for a residential mortgage depends on the loan-to-value ratio, replacing the earlier flat 35 per cent.
• Defaulted exposures. Loans in default are weighted at 100 or 150 per cent depending on the level of provisions.
• Equity and subordinated debt. Holdings of shares and other banks' capital instruments attract weights well above 100 per cent.

Commitments, guarantees and similar items are first converted to an on-balance-sheet equivalent using a credit conversion factor, which estimates how much will be drawn by the time of default, a simplified version of exposure at default. The revised framework applies a factor of 10 per cent to commitments the bank can cancel unconditionally, which previously carried zero.

Banks may reduce risk-weighted amounts by recognising credit risk mitigation. Eligible financial collateral can be taken into account either by substituting the collateral's risk weight or by reducing the exposure after applying a collateral haircut. Guarantees and credit derivatives from eligible providers allow the guarantor's weight to replace the borrower's for the protected portion.

The original standardised approach dates from the Basel II accord of 2004, which replaced the cruder buckets of Basel I. In December 2017 the Basel Committee finalised a revised version as part of the post-crisis Basel III reforms. The aims were to make the approach more risk-sensitive, to reduce mechanical reliance on external ratings by requiring banks to perform their own due diligence, and to offer a non-ratings route for jurisdictions, such as the United States, that do not permit ratings in regulation.

The same reforms gave the standardised approach a second role. Banks using internal models are subject to an output floor: their total risk-weighted assets may not fall below 72.5 per cent of the amount calculated under the standardised approaches, phased in over several years. Every model-using bank must therefore also run the standardised calculation. The Committee's target date was January 2023; the European Union applied the revised rules from January 2025, and other major jurisdictions have followed on later timetables.

The approach trades accuracy for simplicity. Broad classes mean that borrowers of very different quality can receive the same weight, which may encourage banks to choose the riskier loans within a class. Zero weights for domestic sovereign debt have been criticised for tying banks to their governments. Dependence on external ratings imports the agencies' errors, as the 2008 crisis showed. Supervisors can address risks the weights miss through the Pillar 2 capital requirement. Parallel standardised methods exist for market risk capital and operational risk capital, and together they determine the denominator of the total capital ratio.

• Bank for International Settlements: Basel Framework
• European Banking Authority