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5.4.1
Back-testing is the comparison of predictions with actual outcomes. It is the empirical test of the accuracy and calibration of the estimates, i.e. PDs, LGDs and EADs, associated with borrower and facility ratings, respectively.
5.4.2
At a minimum, banks should:
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develop their own statistical tests to back-test their rating systems;
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establish internal tolerance limits for differences between expected and actual outcomes; and
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have a policy that requires remedial actions be taken when policy tolerances are exceeded.
5.4.3
However, the data to perform comprehensive back testing would not be available in the early stages of implementing an IRB rating system. Therefore, banks should rely more heavily on review of rating system developments, process verification, and benchmarking to assure themselves and other interested parties that there rating systems are likely to be accurate. Validation in its early stages should also depend on a bank’s management exercising informed judgment about the likelihood of the rating system working — not simply on empirical tests.
5.4.4
Where banks rely on supervisory, rather than internal, estimates of risk parameters, they are encouraged to compare realised LGDs and EADs to those set by the SAMA. The information on realised LGDs and EADs should form part of a bank’s assessment of economic capital.
