What is the regulatory PD floor and how does it affect bank capital?

Question

AcadiFi · Accepted Answer

Under Basel III finalization (effective 2023–2028 phase-in), the **PD floor is 0.03% (3 basis points)** for most IRB portfolios. Banks cannot use PD estimates below this floor, even if internal data supports lower values.

Rationale:
1. **Model uncertainty** — estimating ultra-low PDs from limited default data is statistically unreliable
2. **Through-the-cycle conservatism** — long benign periods can produce artificially low PDs that understate long-run risk
3. **Level playing field** — prevents IRB banks from dramatically undercutting standardized capital
4. **Basel III output floor** — caps IRB RWA at 72.5% of standardized RWA, but PD floor adds an additional conservative element

**Exceptions:**
- Sovereigns in domestic currency: no floor historically, though under discussion
- Bank exposures: subject to floor
- Retail QRRE transactors: lower floor of 0.05% for transactor credit cards

Example: Hartwell National Bank's AAA-rated Fortune 100 corporate exposure has modeled PD of 0.012% from internal data. After floor: PD = 0.03%.

Impact on RWA at LGD = 45%, M = 2.5, EAD = $50M:
- Without floor (PD = 0.012%): K ≈ 1.35%, RWA ≈ $8.4M
- With floor (PD = 0.03%): K ≈ 2.14%, RWA ≈ $13.4M

```mermaid
flowchart TD
  A[Internal PD estimate] --> B{Below 0.03%?}
  B -->|Yes| C[Apply floor 0.03%]
  B -->|No| D[Use estimate]
  C --> E[Higher RWA]
  D --> F[Normal RWA]
```

60% RWA increase on prime corporate books. Combined with 72.5% output floor and LGD floors, Basel III final substantially reduces IRB capital relief relative to the pre-2017 framework.

What is the regulatory PD floor and how does it affect bank capital?

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