How does the Basel standardized approach for credit risk assign risk weights and what are the main exposure categories?
I'm studying the Basel framework for FRM II and the standardized approach for credit risk seems straightforward at first — just multiply exposure by a risk weight. But the details of which weight applies to which exposure are tricky. Can someone walk through the main categories and their risk weights?
The Basel Standardized Approach (SA) for credit risk is the simpler of the two main approaches (SA vs IRB). It uses externally assigned credit ratings and regulatory-prescribed risk weights to calculate risk-weighted assets (RWA).
Core Formula:
RWA = Exposure Amount × Risk Weight
Minimum capital = RWA × 8% (or higher with buffers)
Main Exposure Categories and Risk Weights:
| Exposure Type | Rating | Risk Weight |
|---|---|---|
| Sovereigns (AAA to AA-) | AAA to AA- | 0% |
| Sovereigns (A+ to A-) | A+ to A- | 20% |
| Sovereigns (BBB+ to BBB-) | BBB+ to BBB- | 50% |
| Sovereigns (BB+ to B-) | BB+ to B- | 100% |
| Sovereigns (Below B-) | Below B- | 150% |
| Banks (Option 1 — sovereign-based) | One notch below sovereign | Various |
| Banks (Option 2 — bank rating) | AAA to AA- | 20% |
| Banks (Option 2) | A+ to A- | 50% |
| Banks (Option 2) | BBB+ to BBB- | 50% |
| Banks (Option 2) | BB+ to B- | 100% |
| Corporates (AAA to AA-) | AAA to AA- | 20% |
| Corporates (A+ to A-) | A+ to A- | 50% |
| Corporates (BBB+ to BB-) | BBB+ to BB- | 100% |
| Corporates (Below BB-) | Below BB- | 150% |
| Corporates (Unrated) | — | 100% |
| Retail | — | 75% |
| Residential mortgage | — | 35% |
| Commercial real estate | — | 100% |
| Past due loans | — | 150% |
Key Features:
- External Ratings Required — Risk weights depend on ratings from recognized External Credit Assessment Institutions (ECAIs like Moody's, S&P, Fitch).
- Unrated Exposures — Generally receive 100% risk weight, which means no capital benefit from the standardized approach for unrated corporate loans.
- Credit Risk Mitigation (CRM) — Collateral, guarantees, and credit derivatives can reduce the effective exposure or risk weight. Eligible financial collateral (cash, government bonds) provides a direct reduction.
- Sovereign Floor of 0% — OECD sovereigns in their own currency typically receive 0% under national discretion, making government bonds 'capital-free' from a regulatory perspective.
Example Calculation:
Vancouver National Bank holds:
- $500M in AAA sovereign bonds → RWA = $500M × 0% = $0
- $300M in A-rated corporate loans → RWA = $300M × 50% = $150M
- $200M in residential mortgages → RWA = $200M × 35% = $70M
- $100M in unrated corporate loans → RWA = $100M × 100% = $100M
Total RWA = $320M. Minimum capital = $320M × 8% = $25.6M.
Exam Tip: Memorize the key risk weights (0%, 20%, 35%, 50%, 75%, 100%, 150%) and their corresponding exposure types. The exam tests quick application, not derivation.
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