The standardised approach allows for the incorporation of several types of credit risk mitigation in determining the regulatory capital for a claim. For a form of risk mitigation to qualify it should be legally enforceable. This means there should be a strong legal basis for actually obtaining the value of the risk mitigation, when necessary. The precise definition of legally enforceable is given in paragraph 117 and 118 of the BIS II paper.
As with the claims, the risk mitigation types are first categorised. Each category has its own rules for calculating the risk mitigation value. The following categories are identified:

The standardised approach is calculated on the level of claims and not on the level of the counterparty. Each claim is assigned a risk weight, determining the capital necessary. Different rules apply to different type of claims. For this reason the portfolio will need to be divided into different types of claims. Make sure your entire portfolio is divided into one of the following categories. Claims on:

• Past due loans (this supersedes all other categories)
• Sovereigns
  • Sovereigns with central bank specific risk weights
  • Sovereigns without central bank specific risk weights

The formula used to determine the regulatory capital is commonly referred to as the Vasicek model. The purpose of this model is to determine the expected loss (EL) and unexpected loss (UL) for a counterparty, as explained in the previous section. The first step in this model is to determine the expected loss. This is the average credit loss. There is a 50% change of realizing this loss or less. The expected loss is determined using three main ingredients:
PD: Probability of default, the average probability of default over a full economic cycle;
EAD: Exposure at default, the amount of money owed at the moment a counterparty goes into default;

The goal of modelling credit risk is to determine the credit loss distribution. A credit loss is a loss due to debtors who fail to meet their payment obligations in one year. The distribution is a combination of probabilities and losses. For instance:
There is a probability of 2% for a credit loss of €50,000.- or less.
There is a probability of 7% for a credit loss of €100,000.- or less.
There is a probability of 16% for a credit loss of €150,000.- or less.
There is a probability of 31% for a credit loss of €200,000.- or less.
Etc.
These probabilities continue to grow until it is one. The probability of an endless credit loss or less is one. This is because all credit losses are endless or less.

The regulatory capital determines the amount of capital required to cover the risk of losses by banks. For obvious reasons not all sources of capital qualify as a buffer against risk. For instance, bonds issued by a bank are burdened by a crippling obligation. The bank has to repay the loan. This means that this money cannot be used to absorb a loss, as eventually the money will have to be raised to repay the bond holders. Only capital without strings attached (or few strings attached) can be used as a buffer. Basically a bank should be able to consume the capital without failing subsequent obligations.
For this purpose the capital eligible as regulatory capital is divided into two types, according to the amount of strings attached.

During the development of the first capital accord it was determined that the main risk of a bank is credit risk. This is the risk that those who have to repay their loans to the bank, don’t. The maximum credit loss that a bank can suffer is equal to the value of all its outstanding loans and investments. This will never occur because it means that all the banks customers will have to go broke. Based on experience it was determined that no more than 8% of the amount of money lend to customers would fail in the most extreme circumstances. In other words 8% of regulatory capital should be present for the banks outstanding loans.

Banks hold a special role in the economy. They function as intermediates between those who have money to spare and those who need money to invest. Basically those who have money to spare open saving accounts at banks. Banks lend that money to those who need it to invest. This is an extremely simplified version of reality but close enough for our purpose.

From the accountants point of view the money deposited at a bank are loans given to the bank. In other words they are liabilities. The loans given by banks are the banks investments. In other words they are assets. Below a simplified balance sheet of a bank is given.

The EaD stands for the Exposure at Default. As a company goes towards default it will normally attempt to increase its leverage (lend more). This is logical because the reason for default is generally a liquidity problem. The EaD model will thus look at the company’s ability to increase its exposure while approaching default. The degree in which this is possible will be dependant on the type of products (facilities) the company has and your banks ability to prevent excessive draw down on facilities. The products can be separated into three main categories.
1. Loans

The Loss Given Default (LGD) is one of the three main ingredients in the Basel model. It represents the percentage of the Exposure at Default (EaD) which you expect to lose if a counterparty goes into default. This chapter will explain the main issues when modeling the LGD.

What determines LGD

To model the LGD it is important to look at what happens after a counterparty goes into default. Dealing with companies who are in financial trouble is a specialty in itself. Most banks therefore have a separate department specialized in handling such companies. The best place to find information on that process after default is this department (often referred to as Special Asset Management).

The purpose of the first pillar is to set out the rules by which the regulatory capital can be calculated. The pillar is divided in three types of risk for which capital should be held.

• Credit Risk
• Operational risk
• Market risk

Credit Risk
Credit risk is the risk that those who owe you money will not pay you back. Historically credit risk is the larges risk banks run. It is at the core of its business. BIS II proposes three approaches by which a bank may calculate its required capital for credit risk.

• Standardised approach
• Internal rating based (IRB) advanced