Backtesting counterparty risk: how good is your model?

Ignacio Ruiz

Abstract

ABSTRACT

Backtesting counterparty credit risk (CCR) models is anything but simple. Such backtesting is becoming increasingly important in the financial industry since both the CCR capital charge and credit valuation adjustment (CVA) management have become even more central to banks. In spite of this, there are no clear guidelines from regulators on 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, we explain a quantitative methodology to backtest counterparty risk models. We expand the three-color Basel Committee scoring scheme from the market risk to the CCR framework. This framework can be applied to single or multifactor models. 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. We have implemented this framework in a Tier-1 financial institution; the model report it generated was sent to the regulators for internal model methods approval. The model was approved a few months later.