An Explanatory Note on the Basel II IRB Risk Weight Functions
In June 2004, the Basel Committee issued a Revised Framework on International Convergence of Capital Measurement and Capital Standards (hereinafter "Revised Framework" or Basel II). This framework will serve as the basis for national rulemaking and implementation processes. The June 2004 paper takes account of new developments in the measurement and management of banking risks for those banks that move onto the "internal ratings-based" (IRB) approach. In this approach, institutions will be allowed to use their own internal measures for key drivers of credit risk as primary inputs to the capital calculation, subject to meeting certain conditions and to explicit supervisory approval. All institutions using the IRB approach will be allowed to determine the borrowers' probabilities of default while those using the advanced IRB approach will also be permitted to rely on own estimates of loss given default and exposure at default on an exposure-by-exposure basis. These risk measures are converted into risk weights and regulatory capital requirements by means of risk weight formulas specified by the Basel Committee.
This paper purely focuses on explaining the Basel II risk weight formulas in a non-technical way by describing the economic foundations as well as the underlying mathematical model and its input parameters. By its very nature this means that this document cannot describe the full depth of the Basel Committee's thinking as it developed the IRB framework. For further, more technical reading, references to background papers are provided.