Validation of banks' internal rating systems: a challenging task?

Abstract

The revised risk-based capital framework (Basel II) developed by the Basel Committee on Banking Supervision (BCBS) aims at further strengthening and stabilizing banking systems around the world. A key element of Basel II is the use of banks’ internal ratings systems for the calculation of the minimum regulatory capital charge. We suggest here a pragmatic approach to assess the validity of such internal rating systems. This approach follows the BCBS principles that were developed on the assumption that a holistic approach for validation has to be taken. Consequently, our approach establishes a broad view on validation. Our goal is to embed into these principles on validation our comprehensive approach that integrates backtesting of rating systems into a top-down assessment of the appropriateness of rating systems. For the purpose of this article the BCBS’ principles mark our starting point.