A Practical Approach to Validating a PD Model

by Lydian Medema of the University of Groningen,
Ruud H. Koning of the University of Groningen, and
Robert Lensink of the University of Groningen

April 2009

Abstract: The capital adequacy framework Basel II aims to promote the adoption of stronger risk management practices by the banking industry. The implementation makes validation of credit risk models more important. Lenders therefore need a validation methodology to convince their supervisors that their credit scoring models are performing well. In this paper we take up the challenge to propose and implement a simple validation methodology that can be used by banks to validate their credit risk modelling exercise. We will contextualise the proposed methodology by applying it to a default model of mortgage loans of a commercial bank in the Netherlands.

JEL Classification: E42, E58, G21.

Keywords: Credit risk, Probability of default, Basel II, Statistical validation, Logit model.

Published in: Journal of Banking & Finance, Vol. 33, No. 4, (April 2009), pp. 701-708.

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