Section 5.0: Risk Weighting Framework for Credit Risk (IRB Approach)
1. Introduction
1.1 Terminology
1.1.1 Abbreviations and other terms used in this paper have the following meanings:
• “PD” means the probability of default of a counterparty over one year.
• “LGD” means the loss incurred on a facility upon default of a counterparty relative to the amount outstanding at default.
• “EAD” means the expected gross exposure of a facility upon default of a counterparty.
• “M” means the effective maturity which measures the remaining economic maturity of a facility.
• “Dilution Risk” means the possibility that the amount of a receivable is reduced through cash or non-cash credits to the receivable’s obligor.
• “EL” means the expected loss on a facility arising from the potential default of a counterparty or the dilution risk relative to EAD over one year.
• “UL” means the unexpected loss on a facility arising from the potential default of a counterparty.
• “IRB Approach” means Internal Ratings-based Approach.
• “Foundation IRB Approach” means that, in applying the IRB framework, banks provide their own estimates of PD and use supervisory estimates of LGD and EAD, and, unless otherwise specified by SAMA, are not required to take into account the effective maturity of credit facilities.
• “Advanced IRB Approach” means that, in applying the IRB framework, banks use their own estimates of PD, LGD and EAD, and are required to take into account the effective maturity of credit facilities.
• “Standardized Approach” means a methodology for calculating capital requirements for credit risk in a standardized manner, supported by credit assessments made by recognized external credit assessment institutions. It is the default option for calculating capital requirements for credit risk, except for banks that have obtained SAMA’s approval to adopt other available options.
• A “borrower grade” means a category of credit-worthiness to which borrowers are assigned on the basis of a specified and distinct set of rating criteria, from which estimates of PD are derived. The grade definition includes both a description of the degree of default risk typical for borrowers assigned the grade and the criteria used to distinguish that level of credit risk.
1.2 Application
1.2.1 The requirements set out in this document are applicable to bank operating in Saudi Arabia which use or intend to use the IRB Approach to measure capital charges for credit risk.
1.2.2 In the case of branches of foreign banking groups, SAMA will, where appropriate, co-ordinate with the home supervisors of those banking groups regarding the application of the requirements of this paper. If such banks plan to adopt in Saudi Arabia any group-wide IRB systems or models, they will need to satisfy SAMA that the relevant systems or models can adequately capture the specific risk characteristics of their domestic portfolios, and that any differences in applying the IRB requirements will not have a material impact on the risk estimates generated. Similarly, SAMA may co-ordinate with the host supervisory authority of Saudi banks overseas branches and subsidiaries.
1.2.3 The requirements set out in this paper apply generally to the following exposures1:
• Credit exposures from all on- and off-balance sheet transactions in the banking book;
• Counterparty exposures from over-the-counter derivatives;
1.2.4 Banks adopting an IRB approach are expected to continue to employ an IRB approach. A voluntary return to the standardized or foundation approach is permitted only in extraordinary circumstances, such as divestiture of a large fraction of the bank‘s credit related business, and must be approved by the supervisor.
(Refer para 261, International Convergence of Capital Measurement and Capital Standards – June 2006)
1 As the IRB Approach does not cover trading book exposures (such as debt and equity securities, derivatives, commodities and certain repo-style transactions held in the trading book), banks adopting this approach will be subject to the market risk capital adequacy regime for the reporting and calculation of capital charges against these exposures,- Refer to SAMA‘s Market Risk Amendment Document of Dec. 2004
1.3 Background and Scope
1.3.1 The IRB Approach to credit risk relies on banks’ internally generated inputs in determining the capital requirement for a given exposure. Subject to meeting the minimum qualifying requirements, banks may seek SAMA’s approval to use their internal estimates of risk components in the calculation of capital. In some cases, banks may be required to use supervisory estimates for some of the risk components.
1.3.2 This document describes the weighting framework for credit risk under the IRB Approach, including:
• the definitions of asset classes under the IRB Approach;
• the definitions of the risk components which serve as inputs to the risk-weight functions that produce capital requirements for the UL portion for separate asset classes; the IRB treatment for each asset class, which begins with a presentation of the relevant risk-weight function(s) followed by the risk components and other relevant factors.
1.3.3 The requirements set out in this paper apply to both the Foundation IRB Approach and the Advanced IRB Approach and to all asset classes (see subsection 2.1 below), unless stated otherwise.
1.3.4 Where banks adopt the internal models approach to calculate capital charges for equity exposures, the relevant requirements are set out in section 7 of this document.
1.3.5 In cases where an IRB treatment is not specified, the risk weight for those other exposures is 100% and the resulting risk-weighted assets are assumed to represent UL only.
1.3.6 Once a bank adopts an IRB approach for part of its holdings, it is expected to extend it across the entire banking group. SAMA recognizes however, that, for many banks, it may not be practicable for various reasons to implement the IRB approach across all material asset classes and business units at the same time. Furthermore, once on IRB, data limitations may mean that banks can meet the standards for the use of own estimates of LGD and EAD for some but not all of their asset classes/business units at the same time.
As such, SAMA intends to allow banks to adopt a phased rollout of the IRB approach across the banking group. The phased rollout includes (I) adoption of IRB across asset classes within the same business unit (or in the case of retail exposures across individual sub-classes); (ii) adoption of IRB across business units in the same banking group; and (iii) move from the foundation approach to the advanced approach for certain risk components. However, when a bank adopts an IRB approach for an asset class within a particular business unit (or in the case of retail exposures for an individual sub-class), it must apply the IRB approach to all exposures within that asset class (or sub-class) in that unit.
The plan should be exacting, yet realistic, and must be agreed with the supervisor. It should be driven by the practicality and feasibility of moving to the more advanced approaches, and not motivated by a desire to adopt a Pillar 1 approach that minimizes its capital charge. During the roll-out period, supervisors will ensure that no capital relief is granted for intra-group transactions which are designed to reduce a banking group’s aggregate capital charge by transferring credit risk among entities on the standardized approach, foundation and advanced IRB approaches. This includes, but is not limited to, asset sales or cross guarantees.
(Refer para 258, International Convergence of Capital Measurement and Capital Standards – June 2006)
2. Mechanics of the IRB Approach
2.1 Categorization of Exposures
2.1.1 Under the IRB Approach, banks should categorize exposures in the banking book into broad classes of assets with different underlying risk characteristics, subject to the definitions set out below.
2.1.2 The classes of assets are: (i) corporate; (ii) sovereign; (iii) bank; (iv) retail; and (v) equity. Within the corporate asset class, four sub-classes of specialized lending (see paragraph 2.2.4 below) are separately identified. Within the retail asset class, three sub-classes (see paragraph 2.5.2 below) are separately identified.
2.1.3 The classification of exposures mentioned above is broadly consistent with established banking practice. However, some banks may use different definitions in their internal risk management and measurement systems. While it is not the intention of SAMA to require banks to change the way they manage their business and risks, banks are required to apply the appropriate treatment to each exposure for the purpose of deriving their minimum capital requirements. Banks should demonstrate to SAMA that their methodology for assigning exposures to different asset classes is appropriate and consistent over time.
2.1.4 The size or exposure limits used for defining some corporate or retail exposures are denominated in local currency (see paragraphs 2.2.2, and 2.5.4 below). Banks are generally expected to re-classify such exposures when the exposures are no longer within or above the limits, as the case may be. However, SAMA will be flexible if the need for re-classification arises solely from short-term exchange fluctuations for exposures denominated in foreign currencies. Banks should have appropriate policies in place for determining the circumstances for re-classifying the exposures. For example, these may include situations in which the changes are more permanent in nature, having been caused by a major currency revaluation or a natural growth or reduction in size or exposure. Re-classification of an exposure will not be required if its outstanding balance falls below the relevant limit mainly as a result of repayments or write-offs.
2.2 Definition of Corporate Exposures
2.2.1 In general, a corporate exposure is defined as a debt obligation of a corporation, partnership, or proprietorship. Banks are permitted to distinguish separately exposures to small- and medium-sized entities (“SMEs”).
SME exposures
2.2.2 SME is defined as a corporate where the reported sales1 for the consolidated group of which the firm is a part are less than SR. 15 MM and the max claims on the counterparty are at SR. 10 MM. To ensure that the information used is timely and accurate, banks should obtain the consolidated sales figure from the latest available audited financial statements2 and have it updated at least annually. The basis of consolidation for the borrowing group should follow that used by Banks for their risk management purposes.
2.2.2.1 Banks should manage SME on a pooled basis in their internal risk management systems in the same manner as other retail exposures. This could be as part of a portfolio segment or pool of exposures with similar risk characteristics for risk assessment and quantification.
2.2.2.2 VIP and High Net Worth Private Accounts
These are defined to be exposure to VIP accounts and high net worth individuals that do not meet the criteria for retail exposures under Para 2.5.
Specialized lending (“SL”) exposures
2.2.3 Except otherwise specified, a corporate exposure should be classified as SL if it possesses all of the following characteristics, either in legal form or economic substance:
• the exposure is to an entity (often a special purpose entity (“SPE”)) which was created specifically to finance and/or operate physical assets;
• the borrowing entity has little or no other material assets or activities, and therefore little or no independent capacity to repay the obligation, apart from the income that it receives from the asset(s) being financed;
• the terms of the obligation gives the lender a substantial degree of control over the asset(s) and the income that it generates; and
• as a result of the preceding factors, the primary source of repayment of the obligation is the income generated by the asset(s), rather than the independent capacity of a broader commercial enterprise.
2.2.4 The five sub-classes of specialized lending are project finance, object finance, commodities finance, income-producing real estate, and high-volatility commercial real estate. Each of these sub-classes is defined below.
(Refer para 220, International Convergence of Capital Measurement and Capital Standards – June 2006)
Project finance
2.2.5 Project finance (“PF”) is a method of funding in which the lender looks primarily to the revenues generated by a single project, both as the source of repayment and as security for the exposure. This type of financing is usually for large, complex and expensive installations that might include, for example, power plants, chemical processing plants, mines, transportation infrastructure, and telecommunications infrastructure. PF may take the form of financing of the construction of a new capital installation, or refinancing of an existing installation, with or without improvements.
2.2.6 In such transactions, the lender is usually paid solely or almost exclusively out of the money generated by the contracts for the facility’s output, such as the electricity sold by a power plant. The borrower is usually an SPE that is not permitted to perform any function other than developing, owning, and operating the installation. The consequence is that repayment depends primarily on the project’s cash flow and on the collateral value of the project’s assets. In contrast, if repayment of the exposure depends primarily on a well-established, diversified, credit-worthy, contractually obligated end user for repayment, it is considered a secured exposure to that end user.
Object finance
2.2.7 Object finance (“OF”) refers to a method of funding the acquisition of physical assets (e.g. ships, aircraft, etc.) where the repayment of the exposure is dependent on the cash flows generated by the specific assets that have been financed and pledged or assigned to the lender. A primary source of these cash flows might be rental or lease contracts with one or several third parties. In contrast, if the exposure is to a borrower whose financial condition and debt-servicing capacity enables it to repay the debt without undue reliance on the specifically pledged assets, the exposure should be treated as a collateralized corporate exposure.
Commodities finance
2.2.8 Commodities finance (“CF”) refers to structured short-term lending to finance inventories, or receivables of exchange-traded commodities (e.g. crude oil, metals, or crops), where the exposure will be repaid from the proceeds of the sale of the commodity, and the borrower has no independent capacity to repay the exposure. This is the case when the borrower has no other activities and no other material assets on its balance sheet. The structured nature of the financing is designed to compensate for the weak credit quality of the borrower. The exposure’s rating reflects its self-liquidating nature and the lender’s skill in structuring the transaction rather than the credit quality of the borrower.
2.2.9 Such lending can be distinguished from exposures financing the inventories, or receivables of other more diversified corporate borrowers. Banks are able to rate the credit quality of the latter type of borrowers based on their broader ongoing operations. In such cases, the value of the commodity serves as a risk mitigant rather than as the primary source of repayment.
2.2.10 Income-producing real estate (“IPRE”) refers to a method of providing funding to real estate (such as, office buildings, retail shops, residential buildings, industrial or warehouse premises, and hotels) where the prospects for repayment and recovery on the exposure depend primarily on the cash flows generated by the asset. The primary source of these cash flows would generally be lease or rental payments or the sale of the asset. The distinguishing characteristic of IPRE versus other corporate exposures that are collateralized by real estate is the strong positive correlation between the prospects for repayment of the exposure and the prospects for recovery in the event of default, with both depending primarily on the cash flows generated by a property.
2.2.11 High Volatility Commercial Real Estate
High-volatility commercial real estate (HVCRE) lending is the financing of commercial real estate that exhibits higher loss rate volatility (i.e. higher asset correlation) compared to other types of SL. HVCRE includes:
• Commercial real estate exposures secured by properties of types that are categorized by the national supervisor as sharing higher volatilities in portfolio default rates;
• Loans financing any of the land acquisition, development and construction (ADC) phases for properties of those types in such jurisdictions; and
• Loans financing ADC of any other properties where the source of repayment at origination of the exposure is either the future uncertain sale of the property or cash flows whose source of repayment is substantially uncertain (e.g. the property has not yet been leased to the occupancy rate prevailing in that geographic market for that type of commercial real estate), unless the borrower has substantial equity at risk. Commercial ADC loans exempted from treatment as HVCRE loans on the basis of certainty of repayment of borrower equity are, however, ineligible for the additional reductions for SL exposures described in paragraph 277, International Convergence of Capital Measurement and Capital Standards – June 2006
(Refer para 227, International Convergence of Capital Measurement and Capital Standards – June 2006)
Where SAMA would categorize certain types of commercial real estate exposures as HVCRE in their jurisdictions, it would make public such determinations. SAMA would then ensure that such treatment is then applied equally to banks under their supervision when making such HVCRE loans in that jurisdiction.
(Refer para 228, International Convergence of Capital Measurement and Capital Standards – June 2006)
1 This term is used interchangeably with “turnover” or “revenue”.
2 This does not apply to those customers that are not subject to statutory audit (such as a sole proprietor). In such cases, banks should obtain their latest available management accounts2.3 Definition of Sovereign Exposures
2.3.1 This asset class covers all exposures to counterparties treated as sovereigns under the Standardised Approach, including:
• Sovereigns (and their central banks);
• Public sector entities (“PSEs”) that are treated as sovereigns under the Standardised Approach1;
• Multilateral development banks (“MDBs”) that meet the criteria for a 0% risk weight under the Standardised Approach2; and other entities that receive a 0% risk weight under the Standardised Approach, namely, World Bank, the Bank for International Settlements, the International Monetary Fund, the European Central Bank and the European Community, Arab Monetary Fund, the Islamic Development Bank.
1 These mainly refer to claims on foreign PSEs that are regarded by the relevant national supervisors as sovereigns in whose jurisdictions the PSEs were established.
2 Eligible MDBs (Standardized Approach)”. Also refer to the section on terminology2.4 Definition of Bank Exposures
2.4.1 This asset class covers exposures to:
• Banks;
• Regulated securities firms (including all security firms licensed CMA) and by the relevant foreign regulators.
• Domestic PSEs that are treated as banks under the Standardised Approach; and
• MDBs that do not meet the criteria for a 0% risk weight under the Standardised Approach.
2.5 Definition of Retail Exposures
General
2.5.1 For an exposure to be categorized as retail, it should satisfy two general criteria:
• The borrower is an individual or a small business that meets a specified exposure threshold (see paragraphs 2.5.3 and 2.5.4 below); and
• The exposure should be one of a large pool of exposures, which are managed by banks on a pooled or portfolio basis1 (see paragraph 2.5.5 below).
2.5.2 Within the retail asset class, banks are required to identify separately three subclasses of exposures:
• Exposures secured by residential properties (see paragraphs 2.5.5 to 2.5.6 below);
• Qualifying Revolving Retail Exposures (QRRE) - (see paragraph 2.5.9 below); and
• All other retail exposures.
Exposures to individuals
2.5.3 Exposures to individuals are generally eligible for retail treatment regardless of exposure size. Such exposures include residential mortgage loans, revolving credits and lines of credit (e.g. credit cards, overdrafts, and retail facilities secured by financial instruments) as well as personal term loans (e.g. installment loans, auto loans, personal finance, and other exposures with similar characteristics).
Small business enterprise
2.5.4 Loans extended to small businesses enterprise and managed as retail exposures are eligible for retail treatment provided the total exposure (On and Off) items of the banking group2 to a small business borrower (on a consolidated basis where applicable3) is less than 5 million Saudi Riyal. Small business loans extended through or guaranteed by an individual are subject to the same exposure threshold.
Exposures secured by residential properties
2.5.5 Residential mortgage loans are eligible for retail treatment regardless of exposure size so long as the credit is extended to an individual and the property is or will be occupied by the borrower, or rented.
2.5.6 Other exposures secured by residential properties that do not satisfy the above requirements should be classified as other retail or corporate exposures, as appropriate.
Qualifying Revolving Retail Exposures (“QRRE”)
2.5.7 A Bank may regard a sub-portfolio of its retail exposures (which should be consistent with the Banks segmentation of retail activities generally) as QRRE, subject to the following criteria being met:
• The exposures are revolving, unsecured, and uncommitted (both contractually and in practice). In this context, revolving exposures are defined as those where customers’ outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by banks;
• The exposures are to individuals;
• The maximum exposure to a single individual in the sub-portfolio is SR. 5 million or less;
• Because the asset correlation assumptions for the QRRE risk-weight function are markedly below those for the other retail risk-weight functions at low PD values, banks should demonstrate that the use of the QRRE risk-weight function is constrained to portfolios that have exhibited low volatility of loss rates, relative to their average level of loss rates, especially within the low PD bands. SAMA will, for monitoring purposes, review the relative volatility of loss rates across the QRRE sub-portfolios of banks;
• Data on loss rates for the QRRE sub-portfolio should be retained in order to allow analysis of the volatility of loss rates; and
• Treatment as QRRE is consistent with the underlying risk characteristics of the sub-portfolio.
1 SAMA does not intend to set the minimum number of retail exposures in a portfolio. Banks should establish their internal policies to ensure the granularity and homogeneity of their retail exposures. Also refer to the Standardized Approach.
2 The banking group should, at a minimum, cover all entities within the group that are subject to the capital adequacy regime in Saudi Arabia.
3 The basis of consolidation should follow that used by a bank for its risk management purposes, provided that exposures to the sole proprietors or partners within the borrowing group are included in the consolidation.3. Foundation and Advanced IRB Approaches
3.1 General Requirements
3.1.1 For each of the asset classes covered under the IRB framework, there are three key elements:
• Risk components - estimates of some risk parameters are provided by banks, and some by the supervisory authorities i.e. PD, LGD and EAD.
• Risk-weight functions - the means by which risk components are transformed into risk-weighted assets and therefore capital requirements;
• Minimum requirements - the minimum standards that should be met in order for a bank to use the IRB Approach for a given asset class1
3.1.2 Under the Foundation IRB Approach, as a general rule, Banks provide their own estimates of PD and rely on supervisory estimates for other risk components. Under the Advanced IRB Approach, bank provide their own estimates of PD, LGD and EAD, and their own calculation of M, subject to meeting minimum standards. For both the Foundation and Advanced IRB Approaches, banks should always use the risk-weight functions provided in this paper for the purpose of deriving capital requirements.
1 These minimum requirements are set out in "Minimum Requirements for Internal Rating Systems under IRB Approach" and "Minimum Requirements for Risk Quantification under IRB Approach".
3.2 Corporate, Sovereign and Bank Exposures
3.2.1 Under the Foundation IRB Approach, banks should provide their own estimates of PD associated with each of their borrower grades, but should use supervisory estimates for other risk components, namely, LGD, EAD and M1.
3.2.2 Under the Advanced IRB Approach, Banks should calculate M and provide their own estimates of PD, LGD and EAD.
3.2.3 There is an exception to the general rule for the four sub-classes of assets identified as SL (i.e. PF, OF, CF and IPRE). Banks that do not meet the requirements for the estimation of PD under the Foundation IRB Approach for their SL assets in the corporate asset class are required to map their internal risk grades to five supervisory categories, each of which is associated with a specific risk weight. This is referred to as the “supervisory slotting criteria” approach.
1 Explicit maturity adjustment will not be required under the Foundation IRB Approach. However, SAMA may allow banks which have systems to calculate the adjusted maturities to measure M for each facility.
3.3 Retail Exposures
3.3.1 For retail exposures, banks should provide their own estimates of PD, LGD and EAD. There is no distinction between a foundation and an advanced approach for this asset class.
4. Rules for Corporate, Sovereign and Bank Exposures
4.1 Risk-Weighted Assets for Corporate, Sovereign and Bank Exposures
Formula for derivation of risk-weighted assets
4.1.1 The derivation of risk-weighted assets is dependent on estimates of PD, LGD, EAD and, in some cases, M, for a given exposure. Paragraphs 4.2.7 to 4.2.13 below discuss the circumstances in which the maturity adjustment applies.
4.1.2 Throughout this section, PD and LGD are measured as decimals, and EAD is measured in Saudi Riyals. For exposures not in default, the formula for calculating risk-weighted assets is 1,2
Correlation ® = 0.12 × (1 - EXP (-50 × PD)) / (1 - EXP (-50)) + 0.24 × [1 - (1 - EXP (-50 × PD)) / (1 - EXP (-50))]
Maturity adjustment (b) = (0.11852 - 0.05478 × ln (PD))^2
Capital requirement 3 (K) = [LGD × N [(1 - R)^-0.5 × G (PD) + (R / (1 - R))^0.5 × G (0.999)] - PD x LGD] x (1 - 1.5 x b)^ -1 × (1 + (M - 2.5) × b)
Risk-weighted assets (RWA) = K x 12.5 x EAD
4.1.3 The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD and the bank‘s best estimate of EL (see paragraphs 4.5.1, 4.5.2 and 4.5.5 of ―Minimum Requirements for Risk Quantification under IRB Approach‖). The amount of risk-weighted asset for the defaulted exposure is the product of K, 12.5, and EAD.
4.1.4 Purposely Missing.
4.1.5 Under the IRB Approach for corporate credits, banks are permitted to separately distinguish exposures to SME borrowers (defined as corporate exposures where the reported sales for the consolidated group of which the firm is a part is less than SR 15 million) from those to large firms4. A firm-size adjustment (i.e. 0.04 x (1 - (S-5) / 45)) is made to the corporate risk-weight formula for exposures to SME borrowers. S is expressed as total annual sales in millions of SR with values of S falling in the range of equal to or less than SR 15 million or greater than or equal to SR 5 million. Reported sales of less than SR 5 million will be treated as if they were equivalent to SR 5 million for the purposes of the firm-size adjustment for SME borrowers.
Correlation ® = 0.12 × (1 - EXP (-50 × PD)) / (1 - EXP (-50)) + 0.24 × [1 - (1 - EXP (-50 × PD)) / (1 - EXP (-50))] - 0.04 × (1 - (S - 5) / 10)
In the case where total sales are not a meaningful indicator of firm size for particular companies, SAMA may on an exceptional basis allow banks to substitute total assets of the consolidated group for total sales in calculating the SME threshold and the firm-size adjustment. However, banks should not make use of this special treatment to obtain capital relief.
Risk weights for SL
4.1.6 Banks that do not meet the requirements for the estimation of PD under the IRB Approach for corporate exposures will be required to map their internal grades for the SL exposures to five supervisory categories, each of which is associated with a specific risk weight. The slotting criteria on which this mapping should be based are provided in Table 2.
4.1.7 The risk weights for UL associated with each supervisory category broadly correspond to a range of external credit assessments5 as outlined below:
* Strong Good Satisfactory Weak Default 70% 90% 115% 250% 0% BBB- or better BB+ or BB BB-or B+ B to C- Not applicable 4.1.8 Subject to SAMA approval a Bank may assign preferential risk weights of 50% to ―"strong" exposures, and 70% to ―"good" exposures, provided they have a remaining maturity of less than 2.5 years or if SAMA determines that a Banks' underwriting and other risk characteristics are substantially stronger than specified in the slotting criteria for the relevant supervisory risk category.
4.1.9 Banks that meet the requirements for the estimation of PD are able to use the Foundation IRB Approach for corporate exposures to derive risk weights for SL sub-classes.
4.1.10 Banks that meet the requirements for the estimation of PD and LGD and/or EAD are able to use the Advanced IRB Approach for corporate exposures to derive risk weights for SL sub-classes.
1 In denotes the natural logarithm.
2 N(x) denotes the cumulative distribution function for a standard normal random variable (i.e. the probability that a normal random variable with mean zero and variance of one is less than or equal to x). G(z) denotes the inverse cumulative distribution function for a standard normal random variable (i.e. the value of x such that N(x) = z). The normal cumulative distribution function and the inverse of the normal cumulative distribution function are, for example, available in Excel as the functions NORMSDIST and NORMSINV.
3 If this calculation results in a negative capital charge for any individual sovereign exposure, banks should apply a zero capital charge for that exposure.
4 Banks should not apply a firm-size adjustment to a corporate customer which cannot make available the sales figure for the consolidated group of which the customer is a part. Also refer to Table –1 on Page 41 for Illustration.
5 The notations follow the methodology used by Standard & Poor‘s. The use of Standard & Poor‘s credit ratings is for reference only; those of some other SAMA approved external credit assessment institutions ("ECAIs") could equally well be used.
* Refer to Table-2 – Attachment 5.9.4.2 Risk Components
Probability of default (PD)
4.2.1 For corporate and bank exposures, the PD is the greater of the one-year PD associated with the internal borrower grade to which that exposure is assigned, or 0.03%. For sovereign exposures, the PD is the one-year PD associated with the internal borrower grade to which that exposure is assigned. The PD of borrowers assigned to a default grade(s), consistent with the reference definition of default, is 100%. The minimum requirements for the derivation of the PD estimates associated with each internal borrower grade are outlined in paragraphs 4.4.1 to 4.4.9 of “Minimum Requirements for Risk Quantification under IRB Approach”.
Banks where, SAMA has disallowed the application of foundation or advanced approaches to HCVRE must map their internal grades to five supervisory categories, each of which is associated with a specific risk weight. The slotting criteria on which this mapping must be based are the same as those for IPRE, as provided in Annex 6 International Convergence of Capital Measurement and Capital Standards – June 2006, . The risk weights associated with each category are:
Supervisory categories and UL risk weights for high-volatility commercial real estate.
Strong
Good
Satisfactory
Weak
Default
95%
120%
140%
250%
0%
(Refer para 280, International Convergence of Capital Measurement and Capital Standards – June 2006)
Table 1: Illustrative IRB risk weights for UL
Asset Class: Corporate Exposures Residential Mortgages Other Retail Exposures Qualifying Revolving Retail Exposures (%) (%) (%) (%) LGD: 45 45 45 25 45 85 45 85 Maturity 2.5 years Turnover (SR. Mn) 500 50 PD: 0.03 14.44 11.30 4.15 2.30 4.45 8.41 0.98 1.85 0.05 19.65 15.39 6.23 3.46 6.63 12.52 1.51 2.86 0.10 29.65 23.30 10.69 5.94 11.16 21.08 2.71 5.12 0.25 49.47 39.01 21.30 11.83 21.15 39.96 5.76 10.88 0.40 62.72 49.49 29.94 16.64 28.42 53.69 8.41 15.88 0.50 69.61 54.91 35.08 19.49 32.42 61.13 10.04 18.97 0.75 82.78 65.14 46.46 25.81 40.10 75.74 13.08 26.06 1.00 92.32 72.40 56.40 31.33 45.77 86.46 17.22 32.53 1.30 100.95 78.77 67.00 37.22 50.80 95.95 21.02 39.70 1.50 105.59 82.11 73.45 40.80 53.37 100.81 23.40 44.19 2.00 114.86 88.55 87.94 48.85 57.99 109.53 28.92 54.63 2.50 122.16 93.43 100.64 55.91 60.90 115.03 33.98 64.18 3.00 128.44 97.58 111.99 62.22 62.79 118.61 38.66 73.03 4.00 139.58 105.04 131.63 73.13 65.01 122.80 47.16 89.08 5.00 149.86 112.27 148.22 82.35 66.42 125.45 54.75 103.41 6.00 159.61 119.48 162.52 90.29 67.73 127.94 61.61 116.37 10.00 193.09 146.51 204.41 113.56 75.54 142.69 83.89 158.47 15.00 221.54 171.91 235.75 130.96 88.60 167.36 103.89 196.23 20.00 238.23 188.42 253.12 140.62 100.28 189.41 117.99 222.86 Note:
1. The above table provides illustrative risk weights for UL calculated for the corporate asset class and he three retail sub-classes under the IRB Approach to credit risk. Each set of risk weights is produced using the appropriate risk-weight functions set out in this paper. The inputs used to calculate the illustrative risk weights include measures of PD, LGD, and an assumed M of 2.5 years.
2. A firm-size adjustment applies to exposures made to SME borrowers (defined as corporate exposures where the reported sales for the consolidated group of which the firm is a part is less than SR 250 million). Accordingly, the firm-size adjustment is made in determining the second set of risk weights provided in second column of corporate exposures given that the turnover of the firm receiving the exposure is assumed to be SR 5 million.
Loss given default (LGD)
4.2.2 Banks should provide an estimate of the LGD for each corporate, sovereign and bank exposure. There are two approaches for deriving this estimate: the Foundation IRB Approach and the Advanced IRB Approach.
LGD under the Foundation IRB Approach
Treatment of unsecured claims and non-recognised collateral
4.2.3 Under the Foundation IRB Approach, senior claims on corporates, sovereigns and banks not secured by recognised collateral will be assigned a 45% LGD.
4.2.4 All subordinated claims on corporates, sovereigns and banks will be assigned a 75% LGD. A subordinated loan is a facility that is expressly subordinated to another facility.
LGD under the Advanced IRB Approach
4.2.5 Subject to the minimum requirements specified in subsection 4.5 of “Minimum Requirements for Risk Quantification under IRB Approach”, banks are allowed to use their own internal estimates of LGD for corporate, sovereign and bank exposures. The LGD should be measured as a percentage of the EAD. Banks eligible for the IRB Approach that are unable to meet these minimum requirements should utilise the foundation LGD treatment described in paragraphs 4.2.3 to 4.2.4 above.
Exposure at default (EAD)
4.2.6 The following paragraphs on EAD apply to both on and off-balance sheet positions. All exposures are measured gross of specific provisions or partial write-offs. The EAD on drawn amounts should not be less than the sum of:
(i) The amount by which a bank‘s regulatory capital would be reduced if the exposure were written-off fully; and
(ii) Any specific provisions and partial write-offs.
When the difference between the instrument’s EAD and the sum of (i) and (ii) is positive, this amount is termed a discount. The calculation of risk-weighted assets is independent of any discounts. Under the limited circumstances described in paragraph 380, International Convergence of Capital Measurement and Capital Standards – June 2006, discounts may be included in the measurement of total eligible provisions for purposes of the EL-provision calculation set out in Section III.G, International Convergence of Capital Measurement and Capital Standards – June 2006
SAMA hereby intimates that the approaches laid in Annexure 4 (Treatment of Counterparty Credit Risk and Cross-Product Netting), of the International Convergence of Capital Measurement and Capital Standards, 2006, (with the exception of clauses applicable to netting) for the purpose of computing the credit equivalent amount of Securities Financing Transactions and OTC derivatives that expose a bank to counterparty credit risk, are available to banks and constitute an integral part of the "SAMA Detailed Guidance Document Relating to Pillar 1, June 2006.
(Refer para 334, International Convergence of Capital Measurement and Capital Standards – June 2006)
Effective maturity (M)
4.2.7 For Banks using the Foundation IRB Approach for corporate exposures, the M will be 2.5 years except for repo-style transactions where the M will be 6 months. Banks using any element of the Advanced IRB Approach are required to measure the M for each facility as defined below.
4.2.8 M is defined as the greater of one year and the remaining effective maturity in years. In all cases, the M will be no greater than five years.
4.2.9 For an instrument subject to a determined cash flow schedule, the M is defined as:
Where CFt flows (principal, interest payments and fees) contractually payable by the borrower in periodt .
4.2.10 If a bank is not in a position to calculate the M of the contracted payments as noted above, it is allowed to use a more conservative measure of M. An example of this measurement is the maximum remaining time (in years) that the borrower is permitted to take to fully discharge its contractual obligation (principal, interest, and fees) under the terms of the loan agreement. Normally, this will correspond to the nominal maturity of the instrument.
4.2.11 For derivatives subject to a master netting agreement, the weighted average maturity of the transactions should be used when applying the explicit maturity adjustment. Further, the notional amount of each transaction should be used for weighting the maturity.
4.2.12 For repo-style transactions subject to a master netting agreement, the weighted average maturity of the transactions should be used when applying the explicit maturity adjustment. A five-day floor will apply to the average. Further, the notional amount of each transaction should be used for weighting the maturity.
5 Rules for Retail Exposures
5.1 Risk-Weighted Assets for Retail Exposures
5.1.1 There are three separate risk-weight functions for retail exposures, as defined in paragraphs 5.1.2 to 5.1.5 below. Risk weights for retail exposures are based on separate assessments of PD and LGD as inputs to the risk-weight functions. None of the three retail risk-weight functions contains an explicit maturity adjustment. Throughout this section, PD and LGD are measured as decimals, and EAD is measured in Saudi Riyals.
Residential mortgage exposures
5.1.2 For exposures defined in paragraph 2.5.6 above that are not in default and are secured or partly secured1 by residential mortgages, risk weights are assigned based on the following formula:
Correlation ® = 0.15
Capital requirement (K) = LGD × N[(1 - R)^-0.5 × G (PD) + (R / (1 - R))^0.5 × G (0.999)] - PD x LGD
Risk-weighted assets = K x 12.5 x EAD
5.1.3 The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD (described in paragraphs 4.5.1 to 4.5.2 of "Minimum Requirements for Risk Quantification under IRB Approach") and a banks‘ best estimate of EL (described in paragraph 4.5.5 of the same paper). The amount of risk-weighted asset for the defaulted exposure is the product of K, 12.5, and the EAD.
5.1.4 QRRE For QRRE as defined in paragraph 2.5.8 above that are not in default, risk weights are assigned based on the following formula:
Correlation ® = 0.04
Capital requirement (K) = LGD × N[(1 - R)^-0.5 × G (PD) + (R / (1 - R))^0.5 × G (0.999)] - PD x LGD
Risk-weighted assets = K x 12.5 x EAD
5.1.5 The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD (described in paragraphs 4.5.1 to 4.5.2 of ―Minimum Requirements for Risk Quantification under IRB Approach") and a bank‘s best estimate of EL (described in paragraph 4.5.5 of the same paper). The amount of risk-weighted asset for the defaulted exposure is the product of K, 12.5, and the EAD.
Other retail exposures
5.1.6 For all other retail exposures that are not in default, risk weights are assigned based on the following function, which also allows correlation to vary with PD:
Correlation ® = 0.03 × (1 - EXP (-35 × PD)) / (1 - EXP (-35)) + 0.16 × [1 - (1 - EXP (-35 × PD)) / (1 - EXP (-35))]
Capital requirement (K) = LGD × N[(1 - R)^-0.5 × G (PD) + (R / (1 - R))^0.5 × G (0.999)] - PD x LGD
Risk-weighted assets = K x 12.5 x EAD
5.1.7 The capital requirement (K) for a defaulted exposure is equal to the greater of zero and the difference between its LGD (described in paragraphs 4.5.1 to 4.5.2 of ―Minimum Requirements for Risk Quantification under IRB Approach") and a banks best estimate of EL (described in paragraph 4.5.5 of the same paper). The amount of risk-weighted asset for the defaulted exposure is the product of K, 12.5, and the EAD. 1 This mean that risks weights for residential mortgages also apply to the unsecured portion of such residential mortgages.
5.2 Risk Components
Probability of default (PD) and loss given default (LGD)
5.2.1 For each identified pool of retail exposures, banks are expected to provide an estimate of the PD and LGD associated with the pool, subject to the minimum requirements as set out in “Minimum Requirements for Risk Quantification under IRB Approach”. Additionally, the PD for retail exposures is the greater of the one- year PD associated with the internal borrower grade to which the pool of retail exposures is assigned or 0.03%.
Banks may reflect the risk-reducing effects of guarantees and credit derivatives, either in support of an individual obligation or a pool of exposures, through an adjustment of either the PD or LGD estimate, subject to the minimum requirements in paragraphs 480 to 489 of the International Convergence of Capital Measurement and Capital Standards – June 2006. Whether adjustments are done through PD or LGD, they must be done in a consistent manner for a given guarantee or credit derivative type.
(Refer para 332, International Convergence of Capital Measurement and Capital Standards – June 2006)
Consistent with the requirements outlined above for corporate, sovereign, and bank exposures, banks must not include the effect of double default in such adjustments. The adjusted risk weight must not be less than that of a comparable direct exposure to the protection provider. Consistent with the standardized approach, banks may choose not to recognize credit protection if doing so would result in a higher capital requirement.
(Refer para 333, International Convergence of Capital Measurement and Capital Standards – June 2006)
6. Treatment of Expected Losses and Recognition of Provisions
Calculation of expected losses
A bank must sum the EL amount (defined as EL multiplied by EAD) associated with its exposures (excluding the EL amount associated with equity exposures under the PD/LGD approach and securitization exposures) to obtain a total EL amount. While the EL amount associated with equity exposures subject to the PD/LGD approach is excluded from the total EL amount, paragraphs 376 and 386, International Convergence of Capital Measurement and Capital Standards – June 2006 apply to such exposures. The treatment of EL for securitization exposures is described in paragraph 563, International Convergence of Capital Measurement and Capital Standards – June 2006.
(Refer para 375, International Convergence of Capital Measurement and Capital Standards – June 2006)
6.1 Expected Loss for Exposures other than SL Subject to the Supervisory Slotting Criteria
Banks should calculate the EL as PD x LGD for corporate, sovereign, bank and retail exposures not in default. For corporate, sovereign, bank and retail exposures that are in default, Banks should use their best estimate of EL as defined in paragraph 4.5.5 of “Minimum Requirements for Risk Quantification under IRB Approach”, and banks on the Foundation IRB Approach should use the supervisory LGD. For SL exposures subject to the supervisory slotting criteria, the EL is calculated as described in paragraph 6.2 below.
6.2 Expected Loss for SL Exposures Subject to the Supervisory Slotting Criteria
For SL exposures subject to the supervisory slotting criteria, the EL amount is determined by multiplying by 8% the risk-weighted assets produced from the appropriate risk weights, as specified in the following paragraph, multiplied by EAD.
The risk weights for SL are as follows:
• Strong
5% • Good
10% • Satisfactory
35% • Weak
100% • Default
625% SAMA may allow banks to assign preferential risk weights to other SL exposures falling into the “strong” and “good” supervisory categories as outlined in paragraph 4.1.8 above. The corresponding EL risk weight is 0% for “strong” exposures, and 5% for “good” exposures.
Supervisory categories and the risk weights for HVCRE:
The risk weights for HVCRE are as follows:
Strong
Good
Satisfactory
Weak
Default
5%
5%
35%
100%
625%
Even where, at national discretion, supervisors allow banks to assign preferential risk weights to HVCRE exposures falling into the “strong” and “good” supervisory categories as outlined in paragraph 282, the corresponding EL risk weight will remain at 5% for both “strong” and “good” exposures.
(Refer para 379, International Convergence of Capital Measurement and Capital Standards – June 2006)
Calculation of provisions
6.3 Exposures Subject to the IRB Approach
Total eligible provisions are defined as the sum of all provisions (e.g. specific provisions, partial write-offs, portfolio-specific general provisions such as country risk provisions or general provisions1) that are attributed to exposures treated under the IRB Approach. Specific provisions set aside against equity should not be included in total eligible provisions.
1 Banks adopting Accounting Standard IAS #39 or other similar standard may wish to note that the accounting changes arising the reform could have implications on the scope and extent of general provisions to be included in Supplementary Capital under the revised capital adequacy framework.
6.4 Treatment of Expected Losses and Provisions
Bank using the IRB Approach should compare the amount of total eligible provisions with the total EL amount as calculated within the IRB Approach. In addition, where a bank is also subject to the Standardized Approach to credit risk for a portion of its credit exposures, general provisions can be included in a bank supplementary capital subject to the limit of 1.25% of risk-weighted assets.
Where the EL amount exceed the total eligible provision, banks should deduct the difference from the capital base at 50% from Tier-1 and 50% from Tier -II.
Where the calculated EL amount is lower than the provisions of the bank, its supervisors must consider whether the EL fully reflects the conditions in the market in which it operates before allowing the difference to be included in Tier 2 capital. If specific provisions exceed the EL amount on defaulted assets this assessment also needs to be made before using the difference to offset the EL amount on non-defaulted assets.
(Refer para 385, International Convergence of Capital Measurement and Capital Standards – June 2006)
The EL amount for equity exposures under the PD/LGD approach is deducted 50% from Tier 1 and 50% from Tier 2. Provisions or write-offs for equity exposures under the PD/LGD approach will not be used in the EL-provision calculation.
The treatment of EL and provisions related to securitization exposures is outlined in paragraph 563.
(Refer para 386, International Convergence of Capital Measurement and Capital Standards – June 2006)
7. Exposure Measurement for Off-Balance Sheet Items
For off-balance sheet items, exposure is calculated as the committed but undrawn amount multiplied by a CCF. There are two approaches for the estimation of CCFs: a foundation approach and an advanced approach.
EAD under the foundation approach
The types of instruments and the CCFs applied to them are the same as those in the standardized approach, with the exception of commitments, Note Issuance Facilities (NIFs) and Revolving Underwriting Facilities (RUFs).
A CCF of 75% will be applied to commitments, NIFs and RUFs regardless of the maturity of the underlying facility. This does not apply to those facilities which are uncommitted, that are unconditionally cancellable, or that effectively provide for automatic cancellation, for the example due to deterioration in a borrower’s creditworthiness, at any time by the bank without prior notice. A CCF of 0% will be applied to these facilities.
The amount to which the CCF is applied is the lower of the value of the unused committed credit line, and the value that reflects any possible constraining availability of the facility, such as the existence of a ceiling on the potential lending amount which is related to a borrower’s reported cash flow. If the facility is constrained in this way, the bank must have sufficient line monitoring and management procedures to support this treatment.
In order to apply a 0% CCF for unconditionally and immediately cancellable corporate overdrafts and other facilities, banks must demonstrate that they actively monitor the financial condition of the borrower, and that their internal control systems are such that they could cancel the facility upon evidence of a deterioration in the credit quality of the borrower.
Where a commitment is obtained on another off-balance sheet exposure, banks under the foundation approach are to apply the lower of the applicable CCFs.
EAD under the advanced approach
Banks which meet the minimum requirements for use of their own estimates of EAD, will be allowed to use their own internal estimates of CCFs across different product types provided the exposure is not subject to a CCF of 100% in the foundation approach.
7.1 Exposure Measurement for FX, Interest Rate, Equity, Credit, and Commodity- Related Derivatives
Measures of exposure for these instruments under the IRB approach will be calculated as per the rules for the calculation of credit equivalent amounts, i.e. based on the replacement cost plus potential future exposure add-ons across the different product types and maturity bonds.
8. Scaling Factor for Risk-Weighted Assets
8.1 Application of scaling factor. In determining the minimum capital requirements for the IRB Approach, SAMA will apply a scaling factor which could be either greater than or less than one, to the total amount of credit risk-weighted assets calculated based on the rules set out for all asset classes under the IRB Approach. The use of this scaling factor is to broadly maintain the aggregate level of minimum capital requirements derived from the revised capital adequacy framework.
8.2 The current best estimate of the scaling factor is 1.06. In applying this scaling factor, banks should multiply the total amount of credit risk-weighted assets calculated under the IRB Approach by 1.06 for the computation of the capital adequacy ratio.
8.3 SAMA will finalize the size of the scaling factor with reference to the results of the Quantitative Impact Survey conducted by the Basel Committee on Banking Supervision.