Modelling choices surrounding PIT PD and PD term structure have material consequences on the estimation of provisions and subsequent management decisions. Several methodologies exist with benefits and drawbacks. The choice of methodology is often the result of a compromise between several dimensions, including but not limited to: (i) rating granularity, (ii) time step granularity and (iii) obligor segmentation granularity. It is generally challenging to produce PD term structures with full granularity in all dimensions. Often, one or two dimensions have to be reduced, i.e. simplified.
3.5.2
Institutions should be aware of this trade-off and should choose the most appropriate method according to the size and risk profile of their books. The suitability of a methodology should be reviewed as part of the validation process. The methodology employed can change with evolving portfolios, risk drivers and modelling techniques. This modelling choice should be substantiated, documented and approved by the Model Oversight Committee. Modelling suggestions made by third party consultants should also be reviewed through a robust governance process.
3.5.3
For the purpose of the MMG, minimum expected practices are articulated for the following common methods. Other methodologies exist and are employed by practitioners. Institutions are encouraged to make research and consider several approaches.
(i)
The transition matrix approach,
(ii)
The portfolio average approach, and
(iii)
The Vasicek credit framework.
3.5.4
Irrespective of the modelling approach, institutions should ensure that the results produced by models meet business sense and economic intuition. This is particularly true when using sophisticated modelling techniques. Ultimately, the transformation and the adjustment of data should lead to forecasted PDs that are coherent with the historical default rates experienced by the institution. Deviations should be clearly explained.