Benchmarking low-default portfolios to third-party ratings

ABSTRACT Comparing a bank’s internal credit worthiness ratings to those assigned by major rating agency’s, so-called benchmarking, provides guidance when validating the performance of an internal rating model. Benchmarking supports the main components of a typical validation: first, how well the rating system distinguishes between low and high risk counterparties. Second, whether the average risk assessment materially differs from that of an independent observer and, finally, if the size of deviations is unreasonably large. This article summarizes known techniques for validation purposes and suggests new approaches that quantify answers to the raised questions and, thus, facilitate the improvement of rating models in cooperation with credit experts. Eventually, these methods support the fulfillment of Basel II regulatory demands.