How do banks estimate A-IRB parameters PD, LGD, EAD under Basel?

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AcadiFi · Accepted Answer

Under the Advanced Internal Ratings Based (A-IRB) approach, banks estimate Probability of Default (PD), Loss Given Default (LGD), and Exposure at Default (EAD) using internal models, subject to strict supervisory requirements. **PD estimation:** Banks assign obligors to rating grades based on default drivers (leverage, profitability, coverage, qualitative factors). Each grade is calibrated to a long-run average one-year default rate using at least 5 years of internal default data (7 years for some portfolios). Meridian Trust Bank uses 12 corporate rating grades; grade BBB+ calibrated to 0.28% long-run PD from 11 years of observed defaults. **LGD estimation:** Downturn LGDs must be used — higher of long-run average LGD or LGD observed during economic downturns. Data period minimum 7 years. Collateral workout costs, discount rates (risk-adjusted), and cure rates must be incorporated. Castlebrook Savings uses 45% downturn LGD for senior unsecured corporate facilities vs 28% long-run average. **EAD estimation:** For undrawn commitments, EAD = current drawn + CCF × undrawn, where Credit Conversion Factor is estimated from observed drawdowns prior to default events. Revolving credit might have CCF of 75% (vs 50% standardized). ```mermaid flowchart TD A[A-IRB Parameters] --> B[PD] A --> C[LGD] A --> D[EAD] B --> E[Rating grades
5+ yr data] C --> F[Downturn
7+ yr data] D --> G[CCF
drawdown obs] ``` Supervisory requirements: use test (parameters must be used in actual credit decisions), validation (ongoing backtesting), and floors — PD floor 0.03% for corporate, LGD floors for secured/unsecured exposures post-Basel III finalization.

How do banks estimate A-IRB parameters PD, LGD, EAD under Basel?

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