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Answer: The advanced internal ratings-based approach for credit risk
## Explanation Under the Basel II framework, there are two main approaches for credit risk under the Internal Ratings-Based (IRB) approach: 1. **Foundation IRB Approach**: Banks estimate the Probability of Default (PD), but use supervisory estimates for Loss Given Default (LGD) and Exposure at Default (EAD). 2. **Advanced IRB Approach**: Banks estimate their own parameters for PD, LGD, and EAD. Recovery rates are directly related to LGD since LGD = 1 - Recovery Rate. Therefore, only the **Advanced IRB Approach** allows banks to use their own estimates of recovery rates (through LGD estimation). **Key distinctions:** - **Option A**: Standardized measurement approach for operational risk - uses fixed supervisory factors - **Option B**: Advanced IRB approach - allows own recovery rate estimates ✓ - **Option C**: Foundation IRB approach - uses supervisory LGD estimates - **Option D**: FRTB approach - primarily for market risk, not credit risk recovery rates The correct answer is **B** because the Advanced IRB approach specifically permits banks to use their internal models to estimate LGD, which inherently includes recovery rate estimation.
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Pillar 1 of the Basel II framework allows banks to use various approaches to calculate the capital requirements for credit risk, operational risk, and market risk. Which of the following Basel II approaches allows a bank to use its own estimates of recovery rates?
A
The standardized measurement approach for operational risk
B
The advanced internal ratings-based approach for credit risk
C
The foundation internal ratings-based approach for credit risk
D
The fundamental review of the trading book (FRTB) approach for securitized products
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