A Proposal for a Validation Methodology for the Discriminatory Power of a Rating System Over Time

Validating the discriminatory power of a rating system is not trivial: the underlying default probabilities that determine the discriminatory power change over time due to changes in the macroeconomic environment and the credit portfolio. This paper presents a methodology using Basel II's one-factor model that enables us to take these changes into account. Using the presented methodology, the relation between the systematic factor of the one-factor model and the discriminatory power of a rating system is analyzed. Most importantly, the methodology enables us to introduce a validation procedure that allows us to compare the discriminatory power of a rating system over time