The Basel Committee recently introduced the internal ratings based approach for calculation of regulatory capital. The IRB internal ratings based approach has received much criticism from banks due to confusion over whether to include expected losses and unexpected losses or normally, banks assume that expected losses are covered as part of fees and margins. On the other hand unexpected losses are deemed to part of the capital issue and form part of the capital model.

Let me quickly touch upon the concept of regulatory capital to those who are new here. Regulatory capital is the capital which banks have to maintain compulsorily as a security measures against losses. For a long time now, regulators have been setting capital ratios based on which minimum capital requirements are decided. Basel Committee has always given special importance to the definition of regulatory capital. Under the IRB approach, basel committee proposes to include Expected losses in calculating regulatory capital. This has further complicated matters for banks. However, in a new directive, basel committee has removed expected losses for certain categories such as for corporates, residential mortgages etc. The effect of these changes however remains to be seen.

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