CP10 (Full Document) - European Banking Authority

· Institutions must be able to bring sufficient experience and
judgement to the development, adjustment, interpretation, and
validation of rating systems and estimates, to supplement purely
quantitative techniques.
· The qualitative phase of the institution’s assessment should focus
on how the various information is interpreted to produce final
assignments of the grades or pools and parameter estimates.
Principle 6: Validation processes and outcomes should be subject to
independent review
334. It is important that a credit institution’s validation processes and
results should be reviewed for integrity by parties within its
organisation that are independent of those responsible for the design
and implementation of the validation process. This independent
review may be accomplished using a variety of structural forms. The
activities of the review process may be distributed across multiple
units or housed within one unit, depending on the management and
oversight framework of the institutions. For example, Internal Audit
could be charged with undertaking this review process using internal
technical experts or third parties independent from those responsible
for building and validating the credit institution's rating system.
Regardless of the credit institution's control structure, Internal Audit
has an oversight responsibility to ensure that validation processes
are implemented as designed and are effective.
3.5.2. Validation tools: Benchmarking and Backtesting
335. Annex VII, Part 4, Paragraphs 109 to 113 requires the institution’s
estimation to be accurate and consistent (Paragraph 109), regular
back­testing and benchmarking of their IRB risk quantification for
each grade (Paragraph 110 and 111), ensuring the consistency of
methods and data through time and documenting changes in
methods and data (Paragraph 112), and taking account of
unexpected changes in economic conditions (Paragraph 113). The
following part of these guidelines elaborates on these requirements
and fleshes out the general principles 4 and 5 discussed above.
336. Institutions are expected to provide sound, robust, and accurate
predictive and forward­looking estimates of risk parameters (PD,
LGD and CF). They shall have a system of risk segmentation which
accurately differentiates risk, and a quantification process which
accurately estimates those parameters. The institution’s validation
process has to ensure that these requirements are met on an
ongoing basis.
337. Common quantitative validation tools include backtesting and
benchmarking of the internal rating system outputs. The CRD
explicitly requires institutions to use both tools in their validation
process (Annex VII, Part 4, Paragraphs 110 and 111). Backtesting
consists of checking the performance of the risk rating systems
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