A Practical Approach to Validating a PD Model

The capital adequacy framework Basel II aims to promote the adoption of stronger risk management practices by the banking industry. The implementation makes validation of credit risk models more important. Lenders therefore need a validation methodology to convince their supervisors that their credit scoring models are performing well. In this paper we take up the challenge to propose and implement a simple validation methodology that can be used by banks to validate their credit risk modelling exercise. We will contextualise the proposed methodology by applying it to a default model of mortgage loans of a commercial bank in the Netherlands. JEL classification: E42; E58; G21