First, a bank would assign each of its loans or exposures to an internal grade, which reflects the risk associated to lending to each borrower. A bank would do so by using the expert judgment of senior lenders and its own well-defined internal rating scale and criteria. The bank would then assess the likelihood of default of borrowers in each internal grade, based on its own analysis. Many larger banks are doing this now. It is this assessment of the probability of default that is the core of the internal ratings-based approach. The second step is for the bank to assess the severity of loss should a loan default – most often referred to as the Loss Given Default. The Committee currently envisions two internal ratings-based approaches, a foundation approach and an advanced approach with even higher minimum standards. A key distinction is that under the foundation approach, banks would use supervisory estimates of lossgiven-default based on loan characteristics, while under the advanced approach, they could make use of their own analysis. The third step is to derive the bank’s capital requirement. The Committee will set out the risk weights that correspond to different estimated probabilities of default and loss-given-default. These risk weights are being developed by the Committee as a measure of unexpected loss, reflecting the amount of potential credit loss for each loan. A key aspect of the internal ratings-based approach is the development of rigorous supervisory standards for the assignment and quantification of internal ratings.
Finance will complement - and potentially amplify these initiatives– but it will never substitute for climate policy action. The policy frameworks with the greatest impact will be: time consistent; transparent; target-based; and committed, through treaties, nationally determined contributions (NDCs), domestic legislation and consensus. The 20 countries – including the UK – that have plans to legislate for net zero show what can be done. 9  All speeches are available online at www.bankofengland.co.uk/news/speeches  9  If countries build their track records, their credibility will grow, and the market will allocate capital to deliver the necessary innovation and growth and pull forward the adjustment to a low carbon future. The more prolific the reporting, the more robust the risk management and the more widespread the return optimisation, the more rapidly the insurance sector can build resilience while promoting the transition that our citizens demand. 10  All speeches are available online at www.bankofengland.co.uk/news/speeches  10