Studies on the Validation of Internal Rating Systems

by the Basel Committee on Banking Supervision

May 2005

Executive Summary: 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 to 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 need 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 means 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, in 2002 the Research Task Force (RTF) formed 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 Validation Group consists of representatives from eleven countries.1 The main objectives of the project have been:

• to classify rating systems and their dynamic properties, and to develop a common terminology for validation purposes,
• to review validation methodologies that are currently applied in bank practice, and
• to analyse validation methodologies for the three key risk components probability of default (PD), loss given default (LGD) and exposure at default (EAD) from a theoretical perspective.

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