Journal of Risk Model Validation
ISSN:
1753-9587 (online)
Editor-in-chief: Steve Satchell
Need to know
- The concept of a statistically distinguishable rating scale is introduced.
- It is shown that validation on such a scale is more stable and requires less capital.
- The result is demonstrated for three rating systems
Abstract
This paper proposes a method of designing a statistically distinguishable rating scale that is not excessive in relation to the existing observation statistics. This allows for more stable validation with a fixed maximum number of violations of the Wald criterion compared with the excess scales usually used by banks. The increased validation robustness will reduce the calibration probability of default, providing savings in the capital requirements under the advanced internal ratings-based approach. Theoretical justifications of the effect are presented, along with numerical calculations for three rating scales: two based on publicly available data from rating agencies, and a third on proprietary data from a bank. The proposed method is most relevant for the corporate segment of the loan portfolio.
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