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)