Validation of the Backtesting Process Under the Targeted Review of Internal Models: Practical Recommendations for Probability of Default Models

Abstract

This paper provides practical recommendations for the validation of the backtesting process under the targeted review of internal models (TRIM). It advises on the introductory steps for validating the backtesting process and reviews the available statistical tests for calibration, discrimination and stability backtesting. The TRIM regulatory exercise is an international supervisory initiative that inspects the internal models and related internal risk and governance policies of eurozone banks that are permitted to use the advanced internal risk-based (AIRB) approach. Under the TRIM guidelines, the designated banks should have specific policies and internal guidelines for the validation of the backtesting process. Further, the affected banks are required to validate the entire backtesting process. Addressing these needs, this paper serves as a basis for producing such policies and utilizing appropriate statistical tools for validating the backtesting process. The paper focusses on probability of default models. To date, no academic study has discussed the validation of the backtesting process with reference to the TRIM rules.

Keywords: TRIM, Validation, Backtesting