The model proposed here takes on the Basel Committee on Banking Supervision (Basel II) approach called the “internal ratings-based” (IRB) approach. By this method, “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 are allowed to determine the borrowers’ probabilities of default while those using the advanced IRB approach are permitted to rely on own estimates of loss given default and exposure at default on an exposure-by-exposure basis.”
In the credit business, losses of interest and principal occur all the time - there are always some borrowers that default on their obligations. The losses that are actually experienced in a particular year vary from year to year, depending on the number and severity of default events.
