CP10 (Full Document) - European Banking Authority

inputs to the IRB approach. Supervisors have the responsibility for
assessing the compliance of institutions’ validation of their rating
systems and inputs with the IRB framework’s minimum standards.
Supervisors must ensure that these requirements are met, both as
qualifying criteria and on a continuing basis. Validation is thus a
fundamental aspect of the IRB approach.
What is meant by ‘validation’?
323. In the context of rating systems, the term ‘validation’ encompasses a
range of processes and activities that contribute to an assessment of
whether ratings adequately differentiate risk and whether estimates
of risk components (such as PD, LGD, or CF) appropriately
characterise the relevant aspects of risk. Rating systems and their
outputs are typically used by credit institutions for a range of
different purposes. As a general rule – and without prejudice to the
more general requirements of the use test, which requires
institutions to justify differences between measures used for
regulatory risk parameters and internal purposes – validation by
institutions needs to take into account the specific purpose or
purposes for which a rating system is being used, including whether
appropriate amendments have been made for each purpose.
Supervisors will pay special attention to the validation of IRB
systems for regulatory capital purposes.
324. There are several general principles that underlie the concept of
validation. They can be summarised as follows:
Principle 1: Validation is fundamentally about assessing the
predictive ability of a institution’s risk estimates and the use of
ratings in credit processes
325. An institution’s IRB estimates are intended to be predictive. While
grounded in historical experience, they should also be forwardlooking.
Rating systems should effectively discriminate risk (i.e.,
credits with lower ratings should have a higher risk of loss) and
calibrate risk (i.e., they should accurately quantify the risk of loss).
Rating systems should also be consistent. If the processes that are
used in assigning risk estimates are not accurate, then the risk
estimates may fail to be sufficiently predictive and may under­ or
over­state required regulatory capital. Consequently, validation
should focus on assessing the forward­looking accuracy of the
institution’s risk estimates, the processes for assigning those
estimates, and the oversight and control procedures that are in place
to ensure that the forward­looking accuracy of these estimates is
preserved going forward. As a general rule, the validation process
should prompt a reassessment of the IRB parameters when actual
outcomes diverge materially from expected results.
· In order to ensure the predictive accuracy of its risk estimates as
well as the effective discrimination and calibration of risk, an
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