ING Direct 2013 Annual Report Download - page 270

Risk management continued ING Bank
EC is calculated using the economic values of rating models (PD, EAD and LGD). In line with regulatory requirements, so-called ‘significant
changes’ to these rating models are communicated to the regulator for approval. Significant changes relate to the impact on Credit RWA
(Pillar 1) or to the significance (size) of the model for the ING Bank portfolio.
Credit risk measurement
There are two broad ways to measure credit risk within ING Bank’s portfolio, depending on whether the exposure is booked under an ING
office which is permitted by the DNB to use the Advanced Internal Rating Based (AIRB) approach, or if it falls under the Standardised (SA)
approach. ING Bank does not use the Basel Foundation (FIRB) approach for any portfolio.
Standardised Approach
Unlike the AIRB approach, the standardised approach applies a fixed risk weight to each asset as dictated by the Financial Supervisory
Authorities, and is based on the exposure class to which the exposure is assigned. As such, the Standardised Approach is the least
sophisticated of the Basel II methodologies and is not as sensitive as the risk-based approach. Where external rating agency ratings are
available, they may be used as a substitute to using the fixed risk weightings assigned by the Financial Supervisory Authorities. Because the
underlying obligors are relatively small, the underlying obligors tend not to have external ratings.
Advanced Internal Rating Based Approach
There are four elements which drive the Basel II ‘risk-based approach’ to the determination of the capital base.
Probability of Default (PD): The first is the counterparty’s probability of default, which measures a counterparty’s creditworthiness in terms
of likelihood to go into default. The result of this calculation attempts to measure the senior, unsecured standalone creditworthiness of an
organisation without consideration of structural elements of the underlying transactions, such as collateral, pricing, or maturity. Each
borrower should have a rating which translates to a PD.
Exposure at Default (EAD): The second element is the counterparty’s exposure at default. These models are intended to estimate the
outstanding amount or obligation at the moment of default in the future. Since the fact that a counterparty will go into default is not
known, and the level of outstandings that may occur on that date is also not known, ING Bank uses a combination of statistical, expert
and hybrid models to estimate the Exposure at Default. With the exception of guarantees and letters of credit, the EAD is always equal to
or higher than the associated credit risk outstandings, under the assumption that counterparties tend to absorb liquidity from available
credit resources before financial problems become apparent to the counterparty’s creditors. The EAD is largely a function of the type of
credit facility (revolving, overdraft, term) offered to the borrower.
Loss Given Default (LGD): The third element is the loss given default. These models are intended to estimate the amount ING Bank will lose
when liquidating collateral pledged in association with a given loan or financial obligation, or alternatively, liquidating the company as a
whole, as part of a workout process. LGD models are based on cover types, estimated recovery rates given orderly liquidation, and (in)
direct cost of liquidation.
Maturity (M): The fourth element is the time to the maturity of the underlying financial obligation. Basel II caps the maturity element at five
years, despite the fact that many obligations extend longer than five years.
Expected Loss (EL): The expected loss provides a measure of the value of the credit losses that ING Bank may reasonably expect to incur on
its portfolio. ING Bank must hold a reserve (as part of its capital base) to cover the expected losses in its credit portfolio. In its basic form,
the expected loss can be represented as:
EL = PD * EAD * LGD
Additionally, ING Bank must also maintain a capital buffer against unexpected losses in order to protect itself against credit losses
associated with unusual market events outside of the statistical norms.
Securitisations
ING Bank has implemented the AIRB approach for credit risk. As a consequence, ING Bank uses the Rating Based Approach (RBA) for
investments in tranches of ABS and mortgage-backed securities (MBS) which have been rated by external rating agencies. Rating agencies
which are used by ING Bank under the RBA include: Standard & Poor’s, Fitch, Moody’s and DBRS.
Under the RBA, the RWA are determined by multiplying the amount of the exposure by the appropriate regulatory risk weights,
which depend on:
• The external rating or an available inferred rating;
• The seniority of the position; and
• The granularity of the position.
ING Bank uses the Internal Assessment Approach for the support facilities it provides to Asset Backed Commercial Paper (ABCP) conduit
Mont Blanc Capital Corp., based on externally published rating agency methodologies.
268 ING Group Annual Report 2013