Modelling IRB Risk‐Weighted Assets: Looking Beyond Stress Tests

ABSTRACT We propose an enhanced methodology for modelling forward‐looking projections of banks' credit risk IRB risk‐weighted assets (RWA), a critical component of regulatory capital adequacy ratios. Our approach focuses on granular modelling of the internal risk structure of banks' IRB portfolios, offering more accurate estimations compared to the traditional aggregate‐level methods commonly used by many regulatory stress testing frameworks. This improvement seeks to reduce the risk of significant misestimation of RWA, which can distort solvency measures and mislead perceptions of banks' financial health. Our methodology is straightforward to replicate and applicable to various uses, including not only stress testing but also calibrations of macroprudential tools. We demonstrate the advantages of our approach over traditional methods and apply it to estimate the impact of cyclical credit parameters deterioration on RWA and the corresponding calibration of the countercyclical capital buffer (CCyB) for the Czech banking sector.