Standardised Credit-Risk Approach and Risk-Weighted Assets - Article

Introduction

A bank does not maintain the same amount of capital against every ₹100 of exposure.

The amount of regulatory capital depends partly on the riskiness of the exposure.

For example, an exposure to the Central Government does not carry the same credit risk as an unsecured exposure to a weak corporate borrower.

The Standardised Approach therefore follows a basic process:

Exposure → Exposure Category → Rating/Regulatory Rule → Risk Weight → RWA

The current IIBF CAIIB BFM Module B specifically includes Capital Charge for Credit Risk under “Risk Regulations in Banking Industry”.

Under RBI’s current Commercial Banks – Prudential Norms on Capital Adequacy Directions, 2025, banks covered by the Directions are required to follow the Standardised Approach for computing the capital charge for credit risk. The approach uses ratings from RBI-accredited external rating agencies where applicable or specific risk weights prescribed by RBI.

For CAIIB numerical questions, the most important rule is:

Do not assign a risk weight until you have correctly classified the exposure.

Learning Objectives

After studying this topic, you should be able to:

• understand the Standardised Approach to credit risk;

• calculate RWA from exposure and applicable risk weight;

• select risk weights for important exposure categories;

• use external ratings correctly;

• understand regulatory retail and housing-loan treatment; and

• avoid common CAIIB errors involving ratings, NPAs and off-balance-sheet items.

What Is the Standardised Approach?

Under the Standardised Approach, the regulator largely prescribes how an exposure must be risk weighted.

The bank first identifies the nature of the claim.

Examples include:

• sovereign;

• bank;

• corporate;

• NBFC;

• regulatory retail;

• residential mortgage;

• commercial real estate;

• NPA; or

• another specified exposure.

The applicable risk weight may then depend on factors such as:

• external credit rating;

• counterparty category;

• loan purpose;

• LTV ratio;

• NPA provisioning;

• maturity; or

• specific RBI prescription.

The international Basel framework follows the same broad concept: under the Standardised Approach, RWA is calculated by multiplying exposure amounts by standardised risk weights. External ratings may be used where the national framework permits them.

Core RWA Calculation

RWA = Exposure Amount × Applicable Risk Weight

The formula converts the nominal credit exposure into its regulatory risk-weighted amount.

Refer to the Formula Section for a detailed explanation, variables, and solved examples.

A 0% risk-weighted exposure therefore contributes no credit RWA, while exposures carrying 100%, 125% or 150% risk weights progressively generate larger RWA for the same exposure amount.

Basic Calculation Sequence

For CAIIB numerical questions, use this order.

Step 1: Identify the Exposure Amount

Determine the amount on which the risk weight is to be applied.

Check whether the figure is:

• outstanding exposure;

• net exposure after eligible adjustment;

• contingent amount; or

• another prescribed regulatory exposure amount.

Step 2: Classify the Counterparty or Exposure

Determine whether it is:

• Government;

• bank;

• corporate;

• NBFC;

• retail;

• housing;

• CRE;

• NPA; or

• another special category.

Step 3: Check Whether an External Rating Is Relevant

For rated corporate and certain other exposures, identify the applicable RBI-recognised rating.

Step 4: Select the Correct Risk Weight

Apply the prescribed risk weight for that exposure class.

Step 5: Calculate RWA Separately for Each Exposure

Do not average risk weights first.

Step 6: Add the Individual RWAs

The resulting total becomes part of the bank’s credit-risk RWA.

Claims on Domestic Sovereigns

Under the current RBI Directions:

• fund-based and non-fund-based claims on the Central Government attract 0% risk weight;

• claims guaranteed by the Central Government also attract 0%;

• direct loans, credit or overdraft exposure to State Governments and investments in State Government securities attract 0%; and

• State Government guaranteed claims attract 20% risk weight.

This distinction is important.

Exam Trap

State Government security = 0%

but

State Government guaranteed claim = 20%

Do not assume every State Government-related exposure receives 0%.

Corporate and NBFC Exposures

For domestic corporates and NBFCs other than Core Investment Companies, RBI currently maps long-term domestic ratings as follows:

*Important exceptions apply to specified large unrated banking-system exposures.

Large Unrated Exposures

An otherwise unrated corporate/NBFC claim attracts 150% where:

• aggregate exposure from the banking system exceeds ₹200 crore; or

• aggregate banking-system exposure exceeds ₹100 crore, the exposure was rated earlier and subsequently became unrated.

Core Investment Companies are separately prescribed a 100% risk weight, whether rated or unrated.

Short-Term Corporate Ratings

For qualifying short-term exposures, the current RBI domestic mapping is:

Again, the large-unrated-exposure exceptions can increase the risk weight to 150%.

Important Cash Credit Rule

Even if a cash-credit facility is sanctioned for one year or less, RBI treats it as a long-term exposure for rating purposes.

Therefore, the relevant long-term rating is used rather than automatically applying a short-term rating simply because the annual review period is one year.

How Multiple Ratings Are Used

This is highly important for numerical and statement-based questions.

One Rating

Use that rating.

Two Ratings with Different Risk Weights

Use the higher risk weight.

Three or More Ratings

Identify the two lowest risk weights and apply the higher of those two.

In practical terms, this means the second-lowest risk weight.

RBI expressly prescribes this method for multiple rating assessments.

Exam Trap

Do not:

• average the ratings;

• average the risk weights; or

• automatically select the best rating.

Eligible External Ratings

RBI’s current framework recognises specified domestic rating agencies for capital-adequacy risk weighting, including:

• Acuité;

• Brickwork;

• CARE;

• CRISIL Ratings;

• ICRA;

• India Ratings; and

• INFOMERICS.

RBI removed the earlier restrictions on the use of Brickwork Ratings for capital risk weighting in June 2025.

The rating used for Standardised Approach purposes must also satisfy regulatory conditions.

For example:

• only eligible ratings can be used;

• ratings should be used consistently;

• banks cannot cherry-pick whichever rating produces the lowest RWA;

• only solicited ratings are recognised for this purpose; and

• the rating must satisfy RBI’s validity requirements.

Regulatory Retail Portfolio

Not every loan to an individual is automatically a 75% regulatory retail exposure.

Claims qualifying for the Regulatory Retail Portfolio currently receive a 75% risk weight, subject to the prescribed criteria and NPA treatment.

Four important criteria apply.

1. Orientation Criterion

The exposure must be to:

• an individual/persons; or

• a small business.

For this purpose, a small business has average annual turnover below ₹50 crore, determined according to RBI’s prescribed method.

2. Product Criterion

Eligible exposures include specified:

• revolving credit;

• overdrafts;

• term loans;

• leases;

• education loans; and

• small-business facilities and commitments.

3. Granularity Criterion

Aggregate exposure to one counterparty should not exceed 0.2% of the overall regulatory retail portfolio.

4. Low-Value Individual Exposure

Maximum aggregated retail exposure to one counterparty must not exceed ₹7.5 crore.

Important Exclusions

The regulatory retail category excludes specified exposures such as:

• securities investments;

• qualifying residential mortgages;

• commercial real estate;

• consumer credit including personal loans and credit-card receivables;

• capital-market exposures; and

• AIF exposures.

Therefore:

Individual borrower ≠ automatically regulatory retail

All qualifying conditions must be checked.

Residential Housing Loans

Housing-loan numerical questions require special attention because the risk weight can depend on:

• sanction date;

• loan amount; and

• Loan-to-Value ratio.

Under the current RBI Directions, for individual housing loans sanctioned on or after 7 June 2017, the normal framework includes:

For loans sanctioned from 16 October 2020 to 31 March 2023, RBI prescribed a special temporary framework irrespective of loan amount:

• LTV ≤80% → 35%

• LTV >80% and ≤90% → 50%.

The current Directions therefore retain sanction-date-specific treatment.

LTV Calculation

RBI determines LTV using:

• total outstanding, including principal, accrued interest and relevant charges; and

• realisable value of the mortgaged residential property.

A CAIIB question giving housing-loan sanction date should therefore not be solved by using one universal housing risk weight.

Commercial Real Estate

Current RBI treatment includes:

• CRE-RH: 75%

• CRE other than CRE-RH: 100%.

This creates another important distinction between:

• an eligible individual housing loan; and

• finance classified as commercial real estate.

Non-Performing Assets

An NPA does not necessarily retain the risk weight that applied when it was a performing exposure.

For the unsecured portion of an NPA, other than qualifying residential mortgage cases, RBI currently prescribes:

Qualifying residential mortgage NPAs have a separate 100%/75%/50% framework depending on the level of specific provisions.

Other Important Prescribed Risk Weights

Some current RBI categories that can appear in conceptual or numerical questions include:

RBI currently prescribes 125% for consumer credit including personal loans, while excluding housing, education, vehicle loans and loans secured by gold/gold jewellery from that particular prescription. Credit-card receivables attract 150% or higher where required.

Off-Balance-Sheet Credit Exposure

Credit risk is not limited to funded loans.

Examples include:

• guarantees;

• Letters of Credit;

• commitments; and

• other contingent exposures.

For an eligible non-market-related off-balance-sheet transaction, RBI first converts the notional exposure into a credit-equivalent amount using the applicable Credit Conversion Factor. The resulting amount is then risk weighted according to the relevant counterparty, purpose or asset treatment.

Credit-Equivalent Amount = Off-Balance-Sheet Amount × Applicable CCF

RWA = Credit-Equivalent Amount × Applicable Risk Weight

These formulas convert a contingent facility into the credit exposure used for regulatory risk weighting.

Refer to the Formula Section for a detailed explanation, variables, and solved examples.

Important current CCFs include:

• direct credit substitutes – 100%;

• transaction-related contingencies – 50%;

• short-term self-liquidating trade LCs – 20%;

• certain commitments up to one year – 20%;

• certain commitments over one year – 50%;

• qualifying unconditionally cancellable commitments – 0%, subject to conditions.

Detailed off-balance-sheet calculations should be studied separately where the syllabus treats them as a dedicated numerical area.

Effect of Risk Weight on Capital Requirement

A higher risk weight increases RWA.

If regulatory capital remains unchanged:

Higher RWA → Lower CRAR

Therefore, changes in:

• external rating;

• exposure classification;

• NPA status;

• LTV;

• regulatory prescription; or

• recognised credit-risk mitigation

can affect capital adequacy even when the nominal exposure amount remains unchanged.

This is the fundamental connection among:

Credit Risk → RWA → Capital Requirement → CRAR

Practical Banking Application

Suppose a bank is preparing its regulatory capital calculation.

It has exposures to:

• Government;

• rated corporates;

• unrated businesses;

• retail borrowers;

• housing borrowers;

• NPAs; and

• guarantee/LC customers.

The bank should not multiply the entire credit portfolio by one common risk weight.

It must:

1. classify exposures;

2. identify eligible ratings;

3. apply prescribed risk-weight mappings;

4. check special categories;

5. apply eligible CCFs to contingent exposures;

6. recognise permitted credit-risk mitigation where applicable; and

7. aggregate the resulting RWAs.

This is why accurate master data on:

• ratings;

• sanction dates;

• LTV;

• borrower category;

• NPA status;

• provisions; and

• facility type

is essential for regulatory capital computation.

CAIIB Exam Focus

Remember these high-value concepts:

• Current RBI directions require the Standardised Approach for credit-risk capital calculation for covered commercial banks.

• RWA is based on exposure multiplied by the applicable regulatory risk weight.

• Exposure classification comes before risk-weight selection.

• Central Government claims and guarantees normally attract 0%.

• State Government securities/direct claims attract 0%, while State Government guaranteed claims attract 20%.

• Domestic long-term corporate rating mapping is AAA 20%, AA 30%, A 50%, BBB 100%, BB and below 150%.

• Unrated corporate claims normally carry 100%, subject to specified 150% rules for large banking-system exposures.

• Cash-credit facilities use long-term ratings even where sanctioned/reviewed for one year.

• With two ratings, use the higher risk weight.

• With three or more ratings, use the second-lowest risk weight.

• Qualifying regulatory retail claims attract 75%.

• Regulatory retail exposure to one counterparty cannot exceed ₹7.5 crore and must satisfy the other prescribed criteria.

• Housing-loan risk weighting depends on applicable sanction-date, amount and LTV rules.

• CRE-RH attracts 75%, while other CRE attracts 100%.

• NPA risk weight can change according to specific provisioning.

• Off-balance-sheet exposures first require conversion to credit-equivalent exposure using the applicable CCF.

• A lower external rating generally produces higher RWA and therefore greater capital requirement.

Common Exam Traps

Trap 1: “All Bank Assets Carry 100% Risk Weight”

Incorrect.

Risk weights differ significantly according to counterparty and exposure category.

Trap 2: “Unrated Corporate Always Means 100%”

Incorrect.

Specified large unrated banking-system exposures attract 150%.

Trap 3: “Choose the Best Rating Where Two Ratings Exist”

Incorrect.

If two ratings map to different risk weights, use the higher risk weight.

Trap 4: “Average Three Different Risk Weights”

Incorrect.

For three or more ratings, use the second-lowest risk weight under the RBI rule.

Trap 5: “Every Individual Loan Qualifies for 75% Retail Risk Weight”

Incorrect.

The regulatory retail exposure must meet all prescribed qualifying criteria and exclusions.

Trap 6: “All Housing Loans Attract 35%”

Incorrect.

Risk weight can depend on sanction date, loan amount and LTV.

Trap 7: “NPA Uses the Same Risk Weight as the Performing Loan”

Incorrect.

Special NPA risk weights apply, including treatment based on specific provisions.

Trap 8: “A ₹100 Off-Balance-Sheet Facility Automatically Creates ₹100 of Credit Exposure”

Incorrect.

The applicable CCF is first used to determine the credit-equivalent amount before risk weighting.

Memory Technique

Remember C-R-W-A:

• C – Classify the exposure

• R – Rating or regulatory rule

• W – Weight the exposure

• A – Add the resulting RWAs

The most important numerical rule is:

Classify first. Multiply later.