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Credit risk is defined as default risk, i.e., the risk of loss from a borrower's failure to
repay the amount owed (principal or interest) to the bank on a timely manner based on
a previously agreed payment schedule. Basel has defined this risk as, "the potential that
a borrower or counterparty will fail to meet its obligations in accordance with agreed
terms", and RBI is of the view that, "it is probability of loss associated with diminution in
the credit quality of borrowers or counterparties (guarantors)". On the whole, credit risk is
the probability of loss from a credit transaction. Under Pillar-I of Basel II (2006),
commercial banks are required to compute minimum capital requirement for credit risk as
per standardized approach and Internal Rating-Based (IRB) approach.
In terms of RBI guidelines, Indian banks have migrated to Basel II Accord by
adopting Standardized Approach (SA) w.e.f. March 31, 2009. Now, to initiate the preparation
for implementing advanced approaches of Basel II, RBI released draft paper including
the deadline to complete the whole exercise. Accordingly, the earliest date of
making application by banks to RBI under IRB approach for credit risk (foundation as well
as advanced IRB) is April 1, 2012 and the likely date of approval by RBI is March 31,
2014. In addition, RBI has advised banks to undertake an internal assessment of
their preparedness for migration to advanced approaches for the regulatory capital
purpose. Under the advanced approach of credit risk, the amount of capital that a bank should
hold against a given exposure will be a function of the credit risk of that exposure. The
credit risk, in turn, is a function of four parameters—Probability of Default (PD), Loss
Given Default (LGD), Exposure at Default (EAD), and Maturity (M).
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