# What Is an Advanced Internal Rating-Based (AIRB) Approach?

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## What Is Advanced Internal Rating-Based (AIRB)?

An advanced internal rating-based (AIRB) is tool for measuring risk in which all risk components are calculated internally within a financial institution. AIRB, done under the Basel II Capital Rules for financial institutions, can help an institution reduce its capital requirements and credit risk.

In addition to the basic internal rating-based (IRB) approach estimations, the advanced approach assesses the risk of default using [loss given default (LGD)](https://www.investopedia.com/terms/l/lossgivendefault.asp), [exposure at default (EAD)](https://www.investopedia.com/terms/e/exposure_at_default.asp), and the probability of default (PD).

These three elements help determine the risk-weighted asset (RWA) that is calculated on a percentage basis for the total required capital.

### Key Takeaways

*   An advanced internal rating-based (AIRB) system is a tool for measuring risk used by financial institutions per the Basel II
*   Essentially, AIRB is a way of accurately measuring a financial firm's risk factors.
*   In particular, AIRB is an internal estimate of credit risk exposure based on isolating specific risk exposures such as defaults in its loan portfolio.
*   Using AIRB, a bank can streamline its capital requirements by isolating the specific risk factors that are most serious and downplaying others.

## Understanding Advanced Internal Rating-Based Systems

Implementing the AIRB approach is one step in the process of becoming a Basel II-compliant institution. However, an institution may implement the AIRB approach only if they comply with certain supervisory standards outlined in the [Basel II](https://www.investopedia.com/terms/b/baselii.asp) accord.

Basel II is a set of international banking regulations, issued by the [Basel Committee on Bank Supervision](https://www.investopedia.com/terms/b/baselcommittee.asp) in July 2006, which expand upon those outlined in [Basel I](https://www.investopedia.com/terms/b/basel_i.asp).

These regulations provided uniform rules and guidelines to level the international banking field. Basel II expanded the rules for minimum capital requirements established under Basel I, provided a framework for regulatory review, and set disclosure requirements for assessment of capital adequacy. Basel II also incorporates [credit risk](https://www.investopedia.com/terms/c/creditrisk.asp) of institutional assets.

## Advanced Internal Rating-Based Systems and Empirical Models

The AIRB approach allows banks to estimate many internal risk components themselves. While the empirical models among institutions vary, one example is the Jarrow-Turnbull model. Originally developed and published by Robert A. Jarrow (Kamakura Corporation and Cornell University), along with Stuart Turnbull, (University of Houston), the Jarrow-Turnbull model is a “reduced-form” credit model.

Reduced form credit models center on describing bankruptcy as a statistical process, in contrast with a microeconomic model of the firm's capital structure. (The latter process forms the basis of common "structural credit models.")

The Jarrow–Turnbull model employs a random interest rates framework. Financial institutions often work with both structural credit models and Jarrow-Turnbull ones, when determining the risk of default.

Advanced Internal Rating-Based systems also help banks determine [loss given default (LGD)](https://www.investopedia.com/terms/l/lossgivendefault.asp) and [exposure at default (EAD).](https://www.investopedia.com/terms/e/exposure_at_default.asp)

### Note

Loss given default is the amount of money to be lost in the event of a borrower default; while exposure at default (EAD) is the total value a bank is exposed to at the time of said default.

## Regulation

Set by regulatory agencies, such as the [Bank for International Settlements](https://www.investopedia.com/terms/b/bis.asp), the [Federal Deposit Insurance Corporation](https://www.investopedia.com/terms/f/fdic.asp), and the [Federal Reserve Board](https://www.investopedia.com/terms/f/frb.asp), capital requirements set the amount of [liquidity](https://www.investopedia.com/terms/l/liquidity.asp) is needed to be held for a certain level of assets at many financial institutions.

They also ensure that banks and depository institutions have enough capital to both sustain [operating losses](https://www.investopedia.com/terms/o/operating-loss.asp) and honor withdrawals. AIRB can help financial institutions determine these levels.

## Frequently Asked Questions (FAQs)

## What Is the Difference Between Foundation and Advanced IRB Approach?

Under foundation IRB, banks model Only the probability of default is considered under foundation IRB. Under the advanced version, banks can also model their own loss given default and exposure-at-default levels.

## What Is the Basel II Rating System?

The [Basel II Rating System](https://www.investopedia.com/terms/b/baselii.asp) is a set of international banking regulations that expanded the rules for minimum capital requirements established under Basel I. It provided a framework for regulatory supervision and set new disclosure requirements for assessing the capital adequacy of banks.

## What Are the Three Pillars of Basel II?

Basel II, the second of three Basel Accords, is based on three main "pillars": minimum capital requirements, regulatory supervision, and market discipline.

## The Bottom Line

An advanced internal rating-based (AIRB) is one of several types of systems that measures risk within a financial institution. With AIRB, all risk components are calculated internally within a financial institution. Such risk evaluating systems can help an institution reduce its capital requirements and credit risk.

> **Article Sources**
>
> 1.  Bank for International Settlements. “[Basel II: Revised International Capital Framework](https://www.bis.org/publ/bcbsca.htm).”
>     
> 2.  Jarrow, Robert, et al. “[A Markov Model for the Term Structure of Credit Risk Spreads](https://doi.org/10.1093/rfs/10.2.481).” The Review of Financial Studies, April 1997, 10 (2), 481–523, doi.org/10.1093/rfs/10.2.481
>     
> 3.  Federal Register. “[Regulatory Capital Rules: Risk-Based Capital Requirements for Depository Institution Holding Companies Significantly Engaged in Insurance Activities](https://www.federalregister.gov/documents/2023/11/27/2023-23911/regulatory-capital-rules-risk-based-capital-requirements-for-depository-institution-holding).”
>     
> 4.  Federal Deposit Insurance Corporation. “[Capital](https://www.fdic.gov/resources/supervision-and-examinations/examination-policies-manual/section2-1.pdf).”
>     
> 5.  Global Association of Risk Professionals. "[Foundation IRB](https://www.garp.org/risk-intelligence/credit/foundation-irb-inferior-061623)."
>     
> 6.  Bank for International Settlements. "[History of the Basel Committee](https://www.bis.org/bcbs/history.htm)."