The standardized, the IRB, and the advanced IRB approach

Under Basel II, there are three approaches to calculating credit risk capital; The standardized approach, the IRB approach, and the advanced IRB approach. Banks can choose between these depending on their sophistication.

The standardized approach is similar to that under Basel I, except for how risk weights are calculated. External ratings are used to determine capital requirements.

The internal ratings based (IRB) approach bases the capital requirement on the one year value at risk. The capital required is the value at risk minus the expected loss. The banks supply their own calculations of the probability of default, while loss given default, exposure at default and maturity of the exposure is set by the Basel committee.

The advanced IRB approach, banks supply their own estimates of the probability of default, exposure at default, loss given default and the maturity of the exposure.