4. Model Suitability

Essential Requirements

Essential requirements for a credit assessment procedure:

1. PD: The target value of the model must be the probability of default (PD) of the borrower.
2. Completeness: The model must take into account all available information relevant to creditworthiness.
3. Objectivity: The results of the credit assessment procedure must be reproducible by different analysts working with the same initial data set.
4. Acceptance: In the eyes of the user, the credit rating model should assess the borrower's creditworthiness as accurately as possible.
5. Consistency: The model must not contradict accepted economic theories and methods.

Suitability of Individual Model Types

Heuristic methods
Statistical models yield a higher discriminatory power than heuristic methods. The former are generally preferrable when a sufficient data set is available. While the latter can be used, their discriminatory power and forecasting accuracy must be reviewed during validation.

Statistical methods
These methods require a sufficiently large data set for the development of the model, especially with regard to default cases. Not always is such a data set available for all borrower segments. Typical segments where these methods cannot be effectively applied are the following:

• Governments and public agencies
• Banks and other financial services providers
• Large corporate/public companies
• Project finance and other specialized finance

Multivariate Discriminant Analysis
MDA imposes the following requirements on input data:

• quantitative
• normally distributed
• same variance/covariance matrix for default and non-default groups

If these requirements are not met the method will not attain the maximum discriminatory power. If this method is used anyway, during validation the bank should review the effects of the unmet requirements on the discriminatory power and forecasting accuracy of the resulting model.

Regression models
Can be applied in all rating segments.

Neural networks
Can be applied in all rating segments.
Causal models
Option pricing models
Only applicable to publicly traded companies and financial services providers.

Cash flow (simulation) models
Well suited for specialized lending.