Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,#,Outline,Introduction,Background and Motivation,Fitness for Use of Economic Capital(EC)Models,Providing Confidence Regarding EC Model Assumptions,Assessing the Value of Validation Methodologies,Qualitative Approaches,Quantitative Approaches,Supervisory Concerns and Expectations,Limitations of Validation,Effective Reporting of Model Outputs,Technical Challenges in Testing the Accuracy of EC Models,Assessing Accuracy in the Tails of the Loss Distribution,Example:Alternative Models for Risk Aggregation,OutlineIntroduction,Backgrou,1,Introduction,Background and Motivation,The validation of EC models is at a very preliminary stage,Internal capital adequacy assessment process,(ICAAP):not a model for EC,but an overall framework for assessing if EC is appropriate,EC may be a quantitative component of ICAAP,but it is not required of all banks by supervisors(only the largest),Validation of the quantitative EC component of ICAAP,if there is one,is a component of ICAAP,EC models can be complex,having many components,and it may not be immediately obvious that a such model works satisfactorily,Models may embody assumptions about relationships amongst or behavior of variables that may not always hold(e.g.,stress),Validation can provide a degree of confidence that assumptions are appropriate,increasing the confidence of users in the model outputs,Additionally,validation can be also useful in identifying the limitations of EC models(i.e.,where embedded assumptions do not fit reality),Introduction,Background and M,2,Introduction,Background and Motivation(continued),There exists a wide range of validation techniques,each providing evidence regarding only some of the desirable properties of a model,Such techniques are powerful in some areas(risk sensitivity)but not in others(accuracy of absolute EC or quantile estimator),A range of validation techniques can provide more substantial evidence for or against the performance of the model,Particularly in an environment of good controls and governance,There appears to be scope for the industry to improve the validation practices that shed light on the overall calibration of models,Particularly in cases where assessment of overall capital is an important,application of the model,Introduction,Background and M,3,Fitness for Purpose of Economic Capital Models,In some cases the term validation is used exclusively to refer to statistical ex post validation(e.g.,backtesting of a VaR),In other cases it is seen as a broader but still quantitative process that also incorporates evidence from the model development stage,Herein,“validation”is meant broadly,meaning all the processes that provide evidence-based assessment of a models,fitness for purpose,This assessment might extend to the management and systems environment within which the model is operated,It is advisable that validation processes are designed alongside development of the models,rather than chronologically,This interpretation of validation is consistent with the Basel Committee(2005)in relation to the Basel II Framework,However,that was phrased in terms of the IRB parameters&developed in the context of assessment of risk estimates for use in minimum capital requirements,Validation of EC differs to an IRB model as the output is a distribution rather than a single predicted forecast against which actual outcomes may be compared,Fitness for Purpose of Economi,4,Fitness for Purpose of EC Models(continued),EC are conceptually similar to VaR models,but several differences force validation methods to differ in practice from those used in VaR,Long time horizon,high confidence levels,and the scarcity of data,Full internal EC models are not used for Pillar 1 minimum capital requirements,so fitness for purpose needs to cover a range of uses,Most of which and perhaps all these uses are internal to the firm in question,Note that EC models and regulatory capital serve different objectives&may reasonably differ in some details of implementation,BCBSs,Validation Principle 1,refers to predictive ability of credit rating systems,an emphasis on performance of model forecasts,The natural evolution of this principle for EC is that validation is concerned with the predictive properties of those models,I.e.,embody forward-looking estimates of risk&their validation involves assessing those estimates,so this related principle remains appropriate,Broadly interpreted validation processes set out herein in different ways all provide insight into the predictive ability of EC model,Fitness for Purpose of EC Mode,5,Providing Confidence Regarding EC Model Assumptions,Properties of an EC model that can be assessed using,powerful,tools,and hence that are capable of robust assessment,include:,Integrity of model implementation,Degree to which grounded in historical experience,Sensitivity to risk&to the external environment,Good marginal properties,R