Practical and Theoretical Challenges in Validating Basel Parameters: Key Learnings from the Experience of a Canadian Bank

Posted: 10 May 2006

See all articles by Peter Miu

Peter Miu

McMaster University - DeGroote School of Business

Bogie Ozdemir

Standard & Poor's

Abstract

This paper, inspired by the efforts of a Canadian bank, discusses Basel preparation and validation issues. A comprehensive outcomes analysis (eg, back-testing) framework is presented, including a simulation-based calibration test. A consistent risk rating philosophy - point-in-time (PIT) or through-the-cycle (TTC) - encompasses both the probability of default (PD) and the default correlations, and the validation needs to be consistent with both. Related arguments are made that not only PD itself, but the correlation of PD used in economic capital models should be rating system specific. We need to use a larger PD correlation under a TTC rating system than under a PIT rating system. Furthermore, Basel loss given default may not be appropriate for commonly used internal models, and accordingly adjustments are proposed.

Keywords: Canadian bank, Basel, back-testing, point-in-time, through-the-cycle, PD, TTC, PIT

Suggested Citation

Miu, Peter and Ozdemir, Bogie, Practical and Theoretical Challenges in Validating Basel Parameters: Key Learnings from the Experience of a Canadian Bank. Journal of Credit Risk, Vol. 1, No. 4, Fall 2005, Available at SSRN: https://ssrn.com/abstract=900330

Peter Miu (Contact Author)

McMaster University - DeGroote School of Business ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada
905-525-9140 ext 23981 (Phone)

Bogie Ozdemir

Standard & Poor's ( email )

130 King Street West
Suite 1100, PO Box 486
Toronto, Ontario M5X 1E5
Canada

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