The Analytics of Risk Model Validation

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Validation of internal rating systems and PD estimates*

Dirk Tasche^†† Fitch Ratings Ltd., London, United Kingdom.

Abstract

Based on the theoretical binary classification framework, the notions of discriminatory power of a rating system and calibration of PD (probability of default) estimates are introduced. A variety of tools for measuring and testing discriminatory power and for testing correct calibration is presented.

1 Introduction

This chapter elaborates on the validation requirements for rating systems and probabilities of default (PDs) that were introduced with the New Capital Standards (commonly called ‘Basel II’, cf. BCBS, 2004). We start in Section 2 with some introductory remarks on the topics and approaches that will be discussed later ...