IRB Treatment of Expected Losses and Future Margin Income

July 2001

The purpose of this paper prepared by the Joint Accounting Task Force - Models Task Force Working Group of the Basel Committee (The Joint Working Group) is to further the Committee's dialogue with the industry on the IRB treatment of expected losses and future margin income.

The Internal Ratings Based (IRB) approach as outlined in the January 2001 consultative package (CP2) entails that regulatory capital charges be calibrated to cover both unexpected and expected credit losses in loan portfolios. Although a capital charge for unexpected losses (UL) is uncontroversial, the banking industry's reaction to a capital charge for expected losses (EL) has generally been negative.

In this paper, the Joint Working Group presents a pragmatic approach in which capital requirements would continue to be calibrated toward UL + EL, albeit in combination with a recognition of provisions actually made and, for the retail portfolio, also of future margin income. Under this approach the capital requirements for UL + EL would be allowed to be met by the sum of capital, specific provisions, general loan loss provisions not included in capital, and possibly future margin income, where the combined' contribution of the last three elements would be capped at the EL element of the capital requirement.