Studies on the Validation of Internal Rating Systems (revised)

BCBS Working Papers No 14
May 2005

In June 2004, the Basel Committee on Banking Supervision issued a revised framework on International Convergence of Capital Measurement and Capital Standards (hereafter "Basel II" or the "revised Framework"). When following the "internal ratings-based" (IRB) approach of Basel II, banking institutions will be allowed to use their own internal measures for key drivers of credit risk as primary inputs to their minimum regulatory capital calculation, subject to meeting certain conditions and to explicit supervisory approval.

In light of the requirement under Basel II for banks and their supervisors to assess the soundness and appropriateness of internal credit risk measurement and management systems, the development of methodologies for validating external and internal rating systems is clearly an important issue. More specifically, there is a need to develop tools for validating the systems used to generate the parameters (such as PD, LGD, EAD and the underlying risk ratings) that serve as inputs to the IRB approach to credit risk. In this context, validation comprises a range of approaches and tools used to assess the soundness of these elements of IRB systems.

In anticipation of the need for more knowledge regarding validation methodologies, the Research Task Force (RTF) formed in 2002 a subgroup (the Validation Group) to review and develop research on the validation of rating systems that would be useful to banks and supervisors as they consider options for implementing Basel II. The work of the Validation Group collected in this volume of studies addresses a number of topics on rating system validation, with a particular focus on empirical validation methods.

The studies are structured as follows: Section II provides an introduction to the terminology and a classification of rating systems. It explores how different rating concepts affect the dynamic properties of the PD estimates.

Sections III, IV and V deal with the validation of the three key risk components in the regulatory capital calculation: PD, LGD and EAD. Various quantitative validation methods for rating systems and PD estimates are discussed in Section III. The purpose is to provide a general assessment of methods that measure the discriminatory power of a rating system and the performance of the PD quantification (calibration). The technical details of the quantitative methods are described in an appendix. Section IV deals with the validation of LGD estimates. Compared with the validation of PDs, the literature on LGD validation is still relatively scarce but growing since it is attracting more attention in academia, furthered by the Basel II proposals. The validation of EAD, the third risk component, is discussed in Section V.

Another quantitative approach that can be used as a complement to backtesting is benchmarking of internal estimates against external sources. Several benchmarking concepts are discussed in Section VI. This may be especially promising for supervisory authorities that have access to internal ratings of different banks.