Development and Validation of Key Estimates for Capital Models

Michel Araten

INTRODUCTION

Economic capital models, as well as, Basel II regulatory capital models under the advanced internal ratings-based (AIRB) approach require, at minimum, estimates of three key parameters. The qualification criteria for using the AIRB approach includes demonstrating to the relevant supervisors that these estimates are an appropriate quantification of the risk-rating process that can be validated and that are subject to the control and oversight of independent parties. This chapter deals with methods for estimating the values of these parameters from historical data and with approaches for validation of these estimates for Basel II. The three key parameters are as follows:

(1)	PD: PD, also known as expected default frequency, is the default probability for a borrower over a one year period. It is often associated or mapped to the risk grade or risk rating (RR) of the borrower.
(2)	LGD: LGD, also known as loss severity, is the expected amount of loss on a facility provided to the borrower. Loss given default and recovery (given default) are the mirror images of each other, as they add up to the amount owed by the