Improving regulatory capital allocation: a case for the internal ratings-based approach for retail credit risk exposures

Purpose - The purpose of this study is to demonstrate that the internal ratings-based (IRB) approach provides more effective risk discrimination than the standardized approach when calculating regulatory capital for retail credit risk exposures. Design/methodology/approach - The author uses four retail credit data sets to compare regulatory capital appropriation using the IRB approach and the standardized approach. The author follows the regulatory capital calculation method recommended under Basel III. For the IRB approach, the author uses a logistic regression to determine the probability of default. Findings - The results suggest that the IRB approach provides more effective risk discrimination across individual exposures, which allows more regulatory capital to be held against riskier exposures and less regulatory capital to be held against less risky exposures. The author further argues that the Basel III output floor, as presently constructed, may disincentivize the use of the IRB approach and further diminish the value of secured lending under the IRB approach. To address this issue, the author offers two simple adjustments to the current design of the output floor. Originality/value - While studies have argued the idea of risk-sensitive regulatory capital, the author has not observed any research that empirically compares the risk-sensitivity of regulatory capital across retail credit exposures, which makes up a significant portion of many banks’ credit exposures. This study also highlights what appears to be a major point of concern for the output floor, which is set to be phased in starting January 2022. This is of particular value because this point has not appeared to receive any attention in the literature thus far.