Internal Default Risk Models: Alive and Kicking?

Read Dr. Zazzara's full blog at

On 24 March 2016, the Basel Committee on Banking Supervision issued a controversial proposal to limit and, in some cases, remove the use of internal models to calculate capital requirements for credit risk in the banking book.

The Committee proposed to adopt a “Standardised” framework for Low-Default portfolios - such as Banks, Insurance Companies, Other Financial Institutions, and Large Companies - instead of opting for an Internal Ratings-Based (IRB) approach. This latter method is currently adopted by many banks in Europe and Asia, and by the largest banks in the US and Canada.

Albeit in line with other Committee’s recent proposals aimed at reducing variability in banks’ risk weighted assets, where Internal Models on Market and Operational Risk have been partially and fully constrained respectively, this proposal attracts attention due to the materiality of loan book exposures in banks’ portfolios. In fact, according to recent evidence, around 75% of Banks’ Risk weighted assets are related to Credit Risk in the Banking Book.

Not surprisingly, major international banks and industry associations from all over the world reacted fiercely during the consultation period, defending the use of internal models for capital requirements purposes. Banks would like to preserve the risk sensitivity of the regulatory capital framework (after all, this was the original goal of the Basel Accord), and also their current regulatory capital levels.

I will continue my discussion of this important topic in my Risk Insight Blog, “Internal Default Risk Models: Alive and Kicking?”, which you can read at

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