Credit Risk measurement – Basel II Norms :

The risk which arises on account of default is associated with almost any financial transaction. BASEL-II provides two options for measurement of capital charge for credit risk

1. Standardized Approach (SA) – Under the SA, the banks use a risk-weighting schedule for measuring the credit risk of its assets and off balance sheet positions. A risk weight of 100% indicates that an exposure is included in calculation of assets for full value, by assigning risk weights based on the rating assigned by the external credit rating agencies.

2. Internal Rating Based Approach (IRB) – The IRB approach, on the other hand, allows banks to use their own internal ratings of counterparties and exposures, which permit a finer differentiation of risk for various exposures and hence delivers capital requirements that are better aligned to the degree of risks.

The IRB approaches are of two types:

(i) Foundation: Under this method banks estimate the risk of default or the probability of default associated with each borrower.

(ii) Advanced: Under this method banks are allowed to have additional internal capital to assess additional risk factors.