The Credit Risk Standardized Approach is a methodology used by banks to calculate the capital requirements for credit risk under the Basel framework, specifically Basel II and Basel III. It is one of the approaches under the Basel Accords for assessing the risk of credit losses due to borrower default. This approach is generally applied by banks that do not have the sophisticated systems or approval to use more advanced approaches like the Internal Ratings-Based (IRB) approach.

Below is an overview of the Credit Risk Standardized Approach:

1. Purpose

The Standardized Approach aims to assign risk weights to different categories of assets based on their credit risk. These risk weights are used to determine the amount of capital a bank must hold to cover potential losses from credit defaults.

2. Scope

It applies to a wide range of exposures, including:

• Claims on sovereigns (governments)


• Claims on public sector entities (PSEs)


• Claims on multilateral development banks


• Claims on banks and securities firms


• Claims on corporates


• Retail exposures


• Residential and commercial real estate loans


• Past due exposures


• Other assets

3. Key Features

• Risk Weights: Exposures are assigned predefined risk weights based on the type of counterparty and their external credit ratings (if available). The risk weights are set by the Basel Committee on Banking Supervision and implemented by national regulators.


• External Credit Ratings: For many exposures, risk weights are determined based on ratings provided by recognized external credit assessment institutions (ECAIs), such as Standard & Poor’s, Moody’s, or Fitch.


• Simplicity: Compared to the IRB approach, it is less complex and does not require internal models for risk assessment, making it suitable for smaller or less sophisticated banks.


• Credit Risk Mitigation (CRM): Techniques such as collateral, guarantees, or credit derivatives can be used to reduce the risk-weighted assets (RWA) under certain conditions.

4. Risk Weight Categories (Basel II/III)

The risk weights are assigned based on the creditworthiness of the counterparty. Below are some common risk weights as an example (these may vary based on local regulations or Basel revisions):

• Sovereigns: Risk weights range from 0% (for highly rated sovereigns, e.g., AAA to AA-) to 150% (for below investment grade).


• Banks: Risk weights depend on the bank's rating, ranging from 20% (AAA to AA-) to 150% (below investment grade).


• Corporates: Risk weights range from 20% to 150%, based on external credit ratings.


• Retail: Typically assigned a risk weight of 75% (e.g., personal loans or credit card receivables).


• Residential Real Estate: Often assigned a lower risk weight (e.g., 35%) if specific criteria are met.


• Commercial Real Estate: Higher risk weights (e.g., 50% or more).


• Past Due Exposures: Higher risk weights (e.g., 150%) if loans are past due for more than 90 days.

5. Calculation of Risk-Weighted Assets (RWA)

The RWA for credit risk under the Standardized Approach is calculated as:
RWA = Exposure Amount × Risk Weight

• Exposure Amount: The carrying value of the asset or off-balance-sheet exposure (adjusted by credit conversion factors for off-balance-sheet items).


• Risk Weight: The percentage assigned to the exposure based on counterparty risk.

6. Credit Risk Mitigation (CRM)

Banks can reduce their RWA by applying CRM techniques. Common methods include:

• Collateral: Risk weights are adjusted based on the type and quality of collateral (e.g., cash, government securities).


• Guarantees: A portion of the exposure can be assigned the risk weight of the guarantor if the guarantor has a better credit rating.


• Netting: Offsetting exposures with eligible financial instruments.


• Credit Derivatives: Using credit default swaps or similar instruments to transfer risk.

7. Capital Requirement

Once the RWA is calculated, the minimum capital requirement is determined by multiplying the RWA by the bank's required capital adequacy ratio (e.g., 8% under Basel III for Tier 1 + Tier 2 capital):
Capital Requirement = RWA × 8%

8. Advantages of the Standardized Approach

• Simplicity and transparency, as it relies on standardized risk weights.


• Suitable for smaller banks without advanced risk management systems.


• Less data-intensive compared to the IRB approach.


• Harmonized across jurisdictions, ensuring consistency.

9. Limitations

• Lack of Risk Sensitivity: Risk weights are not tailored to the specific risk profile of individual exposures, as they are based on broad categories or external ratings.


• Dependence on External Ratings: For rated exposures, reliance on external credit ratings can introduce inconsistencies or biases.


• Limited Incentives for Risk Management: Unlike the IRB approach, it does not encourage banks to develop sophisticated internal risk assessment models.

10. Basel III Enhancements

Basel III introduced reforms to the Standardized Approach (finalized in the Basel III reforms of December 2017, also called "Basel IV" by some) to address some limitations:

• Reduced Reliance on External Ratings: For exposures to banks and corporates, alternative risk-weighting methodologies (e.g., based on financial metrics like leverage or revenue) were introduced for jurisdictions that opt out of using external ratings.


• Granularity: More categories and risk weights for exposures like real estate and retail to better reflect risk.


• Constraints on Risk Weights: Introduction of floors and caps to ensure risk weights are neither too low nor too high.

11. Implementation

The Standardized Approach is implemented by national regulators, who may adapt the framework to local conditions. Banks must comply with the rules set by their local supervisory authorities, which are aligned with the Basel guidelines.

Conclusion

The Credit Risk Standardized Approach provides a straightforward and universally applicable method for calculating credit risk capital requirements. While it lacks the risk sensitivity of the IRB approach, it serves as a robust starting point for many banks and ensures a minimum level of capital adequacy. With Basel III reforms, the approach has been refined to balance simplicity with improved risk capture.