What is the difference between the Foundation IRB and Advanced IRB approaches under Basel, and who estimates which parameters?

Under Basel's Internal Ratings-Based (IRB) framework, banks use their own credit risk models to calculate regulatory capital, subject to supervisory approval. There are two variants: Foundation IRB (F-IRB) and Advanced IRB (A-IRB).

The Same Risk-Weight Function

Both approaches feed into the same Basel risk-weight formula (based on the Vasicek/Gordy model), which maps PD, LGD, EAD, and maturity (M) into a capital requirement:

K = LGD x [N((1-R)^{-0.5} x G(PD) + (R/(1-R))^{0.5} x G(0.999)) - PD] x MA

where R = asset correlation, N = normal CDF, G = inverse normal CDF, MA = maturity adjustment.

Who Estimates What

Worked Example

Thornecrest Bank evaluates a $15 million revolving credit facility to Brightwood Logistics under both approaches:

F-IRB Parameters:

• PD (bank estimate): 1.8%
• LGD: 45% (supervisory — senior unsecured)
• EAD: $15M x 75% CCF = $11.25M (supervisory)
• M: 2.5 years (fixed)

A-IRB Parameters:

• PD (bank estimate): 1.8%
• LGD (bank estimate): 32% (strong collateral package)
• EAD (bank estimate): $15M x 60% CCF = $9.0M (based on internal utilization data)
• M (bank estimate): 3.2 years (contractual)

A-IRB produces significantly lower capital because the bank can demonstrate lower LGD (through collateral) and lower EAD (through utilization analysis).

Supervisory Requirements for A-IRB

Banks must demonstrate:

• Minimum 7 years of default data for LGD estimation
• Minimum 5 years for EAD/CCF estimation
• Downturn LGD calibration (losses during stress)
• Regular backtesting and model validation

Exam Tip: If asked which approach is more capital-efficient, A-IRB generally produces lower capital for well-collateralized portfolios — but at the cost of higher data, model, and compliance requirements.

For more on Basel capital frameworks, visit our FRM Part II materials.