Internal Loss Given Default Models Under Basel 3.5

This white paper is focused on the implications of Basel 3.5 regulations for banks using internal Loss Given Default (LGD) models. It discusses the challenges posed by stricter compliance requirements and validation processes that may lead banks to reassess their modeling strategies. The paper explains that, despite these challenges, internal LGD models are crucial for purposes like stress testing and internal capital allocation. The document outlines the need for banks to balance the use of the Standardized Approach and Internal Ratings-Based methods to optimize risk sensitivity and capital allocation. It further details the constraints introduced by Basel 3.5, such as the output floor, which affects the capital savings achievable through internal models. Additionally, the paper addresses issues related to data scarcity and the need for sophisticated modeling techniques, including newer approaches like machine learning to enhance data quality. It highlights the ongoing relevance of internal models for internal assessments and strategic planning within banks.