Rating Models and Validation - Oesterreichische Nationalbank

Rating Models and Validation
Chart 45: Conditional Default Rates (Example: Default Rates on a Logarithmic Scale)
When the Markov property is applied to the transition matrix, the conditional
default rates converge toward the portfolioÕs average default probability
for all rating classes as the time horizon becomes longer. In this process, the
portfolio attains a state of balance in which the frequency distribution of the
individual rating classes no longer shifts noticeably due to transitions. In practice,
however, such a stable portfolio state can only be observed in cases where
the rating class distribution remains constant in new business and general circumstances
remain unchanged over several years (i.e. seldom).
6 Validating Rating Models
The term ÒvalidationÓ is defined in the minimum requirements of the IRB
approach as follows:
The institution shall have a regular cycle of model validation that includes monitoring
of model performance and stability; review of model relationships; and testing
of model outputs against outcomes. 66
Chart 46 below gives an overview of the essential aspects of validation.
The area of quantitative validation comprises all validation procedures in
which statistical indicators for the rating procedure are calculated and interpreted
on the basis of an empirical data set. Suitable indicators include the
modelÕs a and b errors, the differences between the forecast and realized default
rates of a rating class, or the Gini coefficient and AUC as measures of discriminatory
power.
In contrast, the area of qualitative validation fulfills the primary task of
ensuring the applicability and proper application of the quantitative methods
in practice. Without a careful review of these aspects, the ratingÕs intended purpose
cannot be achieved (or may even be reversed) by unsuitable rating procedures
due to excessive faith in the model. 67
66 Cf. EUROPEAN COMMISSION, draft directive on regulatory capital requirements, Annex D-5, No. 18.
67 Cf. EUROPEAN COMMISSION, Annex D-5, No. 41 ff.
94 Guidelines on Credit Risk Management