Explanation:
Under the Basel II framework, the Internal Models Approach (IMA) for market risk allows banks to use their own proprietary risk models (like VaR) to compute capital requirements. By explicitly modelling the correlations among various risk factors (such as interest rates, equities, FX, etc.), the IMA framework explicitly recognizes diversification benefits. The IRB approaches for credit risk and the Standardized Approach for operational risk rely on standardized formulas that do not explicitly permit the modeling of cross-portfolio diversification benefits.
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Q.66 Pillar 1 of the Basel II framework allows banks to use a host of approaches to compute capital requirements for operational risk, credit risk, and market risk. Which of the following Basel II approaches allows a bank to explicitly recognize diversification benefits?
A
The Foundation Internal Ratings Based (IRB) Approach for credit risk
B
The Advanced IRB Approach for credit risk
C
The Standardized Approach for operational risk
D
The Internal Models Approach for market risk
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