Internal Ratings-Based Approach to Specialised Lending Exposures

In the January consultative package (CP), an underlying tenet of the proposed IRB approach for corporate exposures is that the source of repayment of the loan is based primarily on the ongoing operations of the borrower, rather than the cash flow from a project or property. In this context, assets pledged as collateral serve as a risk mitigant and as a secondary source of repayment. Defined as such, the corporate exposure class did not encompass loans which finance income-producing assets, and which are structured in such a way that repayment of the loan depends principally on the cash flow generated by the asset rather than the credit quality of the borrower. This distinction was made for two primary reasons, as noted in the January CP: First, such loans possess unique loss distribution and risk characteristics. In particular, given the source of repayment, the exposures exhibit greater risk volatility - in times of distress, banks are likely to be faced with both high default rates and high loss rates. A second key reason for treating such exposures separately in the IRB framework is that most banks use different internal risk rating criteria for such loans, and may treat them separately in other internal risk management processes. In light of the above, in this paper, the Basel Committee's Models Task Force (MTF) proposes a specific IRB treatment for these exposures, which are referred to collectively as "Specialised Lending" (SL). Please note that these lending activities were collectively referred to as "project finance" in the January CP. Since the publication of the January CP, the MTF's dialogue with the industry has also highlighted that historical loan performance data for SL exposures are scarce. Many banks therefore face difficulties in establishing credible and reliable estimates of key risk factors (including the probability of default), which can be adequately validated by both the bank and its supervisor. As a result, there is no common industry standard for a rigorous, empirical, and risk-sensitive approach to economic capital estimation of SL exposures. In contrast, for corporate exposures, the MTF was comfortable that banks had in place, or could develop within the relevant time frame, internal rating systems capable of assessing the quality of the exposure, and quantifying these assessments. Foundation IRB banks were presumed to be able to provide reasonable estimates of the probability of default (PD), while advanced IRB banks were also presumed to be able to generate reliable estimates of loss-given-default (LGD) and exposure at default (EAD). In light of the above, the proposed IRB framework to SL is based on an evolutionary approach for the assessment of regulatory capital requirements. However, while the evolutionary concept is consistent with that set forward in the January CP, the specifics of the SL approach take into account the different levels of sophistication observed in the industry, as well as the limited data availability. In particular, the proposed IRB framework for SL supplements the foundation and advanced methodologies set forward for corporate exposures with a more basic methodology, which is based on supervisory estimates of PD as well as LGD and EAD.