Validation of the backtesting process under the targeted review of internal models: practical recommendations for probability of default models

Lukasz Prorokowski

Journal of Risk Model Validation

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.

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