Update on work of the Accord Implementation Group related to validation under the Basel II Framework

January 2005

The purpose of this update is to inform the banking industry, the supervisory community and other interested parties about the work that is underway within the Basel Committee's Accord Implementation Group (AIG) in the area of validation under the Basel II Framework.

One of the greatest challenges - for both banks and supervisors - of the Basel II Framework is the need to validate the systems used to generate the parameters that serve as inputs into the internal ratings-based (IRB) approach to credit risk. The Basel II Framework that was released in June 2004 requires banks to assess the ability of a borrower to perform despite adverse economic conditions. Thus, when considering the appropriateness of any rating system as the basis for determining capital, there will always be a need to ensure objectivity, accuracy, stability, and an appropriate level of conservatism.

Internal ratings and default and loss estimates must play an essential role in the credit approval, risk management, internal capital allocation, and corporate governance functions of banks using the IRB approach. The Framework recognises that bank management continues to bear responsibility for validating the inputs to the IRB approach. Supervisors have responsibility for assessing compliance of banks' validation of rating systems and their inputs with the minimum standards of the IRB framework for credit risk. Supervisors must ensure that these requirements are being met, both as qualifying criteria and on a continuing basis. However, it should be noted that supervisors will focus on compliance with the minimum requirements as a means of ensuring the overall integrity of a bank's ability to provide prudential inputs to the capital calculations and not as an end in itself.

Validation is thus a fundamental aspect of the IRB approach, so much so that the AIG has established a Subgroup to examine issues related to validation. This Subgroup is chaired by Mr Lorey Hoffman of the Canadian Office of the Superintendent of Financial Institutions and consists of both Basel Committee member countries and non-G10 countries. The Validation Subgroup (Subgroup) has already begun exploring a range of issues related to validation, and this update will describe the scope of their work plan.