Backtesting Counterparty Risk: How Good is your Model?
Forthcoming publication in the Journal of Credit Risk
Backtesting Counterparty Credit Risk models is anything but simple. Such backtesting is becoming increasingly important in the financial industry since both the CCR capital charge and CVA management have become even more central to banks. In spite of this, there are no clear guidelines by regulators as to how to perform this backtesting. This is in contrast to Market Risk models, where the Basel Committee set a strict set of rules in 1996 which are widely followed. In this paper, the author explains a quantitative methodology to backtest counterparty risk models. He expands the three-color Basel Committee scoring scheme from the Market Risk to the Counterparty Credit Risk framework. With this methodology, each model can be assigned a color score for each chosen time horizon. Financial institutions can then use this framework to assess the need for model enhancements and to manage model risk. The author has implemented this framework in Tier-1 a financial institution; the model report it generated was sent to the regulators for IMM model approval. The model was approved a few months later.