Out-of-Time Validation of Default Probabilities within the Basel Accord: A Comparative Study
Posted: 4 May 2017 Last revised: 19 Nov 2019
Date Written: February 27, 2019
Abstract
The probability of a default determines capital requirements set by the Basel Accord. To back-test default probabilities is therefore possibly the single most important task when validating credit rating models. A proper validation procedure must fulfill two criteria. First, it must be able to detect default probabilities which are too low, i.e. it must have satisfactory power. Second, it must not reject adequate default probabilities, i.e. its type I error should be in line with the significance level of the test. In this paper we compare several validation procedures via a simulation and empirical study. Our result is that many validation procedures do not fulfill both criteria.
Keywords: Validation Default Probabilities Credit Rating Basel Accord
JEL Classification: G21, G24, G28, C11, C12
Suggested Citation: Suggested Citation