To be or not to be IRB

Before management teams make long-term strategic decisions about how much money to invest in Advanced IRB modelling and credit risk mitigation techniques, they need a crystal-clear view of three things: (1) the current and future banking book credit portfolio mix; (2) the credit approval process; and (3) the drivers of capital requirements. Management teams who do not fully understand these components and how they interact might face regulatory restrictions, reputational risks, increased operational costs and insufficient capital management. 

The aim of this paper is to support and guide Nordic bank management teams in their considerations regarding whether the current IRB or Standardised (ST) approach remains suitable for them, given the Basel 3.1 reform. This paper discusses the main differences between the Internal Rating-Based (A-IRB and F-IRB) approaches and the ST approaches, explaining key reflections management teams should consider to assess the relative benefits of the two approaches. This assessment should inform strategic decision-making on whether a bank should transition between the ST and the internal rating-based (A-IRB and -IRB) approaches for one or more portfolios – or vice versa. Transitioning from one approach to another is a significant decision and will impact the full end-to-end credit risk process. We detail the key inputs to decision-making and crucial issues to consider from a modelling perspective, elaborating on the possible benefits and challenges of transitioning in either direction.

Key takeaways

• Basel 3.1 changes how banks calculate capital requirements. Therefore, management teams should revisit their strategic choice regarding the selection of an IRB or ST approach, as a transition of approach for some portfolios could mitigate potential increases in capital requirements plus development and maintenance costs. 
• The expected implementation deadline for Basel 3.1 in the EU is 1 January 2025. Nordic prudential regulators are anticipated to align with this deadline
• The business case for portfolios currently on the A-IRB approach is decreasing due to the higher cost and effort required. This might incentivise a transition to an F-IRB or ST approach.
• Management teams need to identify the portfolios where it makes sense to transition to (or from) the modelling IRB approach, considering the financial impact of the proposed changes as part of a comprehensive business case which supports, and reinforces, the rationale for the selected approach. 
• There is an increasing trend for banks moving portfolios (or entirely) from IRB to ST, but this requires significant effort to deliver. Mapping the implications for credit risk modelling and making development choices to optimise strategic business benefits within new regulatory constraints is not trivial in practice, as the full end-to-end credit process needs to be considered. 
• The end-to-end credit process analysis is challenging but extremely important for management decision-making, as the consequences of inadequate analysis can lead to increased costs and greater regulatory scrutiny on related topics, if the perception is that risk management is not adequate.

Where management teams have decided to transition from the current approach, it is essential to engage with regulators and also investors effectively to ensure a successful application and prepare senior stakeholders for the expected changes. Regulatory affairs teams need to proactively manage the relationship with regulators, with strong and consistent communication management before and during the application period. Applications to move to IRB or revert to an ST approach need to be actively managed, across application drafting, quality assurance and governance processes, involving stakeholders and collating supporting documents on a structured and timely basis.