Suppose that the assets of a bank consist of $500 million of loans to A-rated corporations. The PD for the corporations is estimated as 0.3%. The average maturity is three years and the LGD is 60%.

1. What are the expected losses and unexpected losses for the loans under foundation IRB approach? A rating corresponds to 0.01% of default rate.

2. How much capital is needed for the loans under the foundation IRB approach?

3. How does the capital required in foundation IRB compare with the capital required under the Basel II standardized approach? Calculate both and illustrate why one is higher than the other.

4. If analysts of the bank forecast an increase of risk in corporate debt market, which leads to a higher PD and LGD, what should the bank do to manage the credit risk?