Backtesting to support specific risk measurement

In September 1997, the Basel Committee on Banking Supervision released a modification
(1997a,b) to the Amendment to the Capital Accord to include market risks
(1996) to allow banks to use their internal models to measure specific risk for
capital requirements calculation. This document specified additional backtesting
requirements to validate specific risk models. The main points were:
Ω Backtesting must be done at the portfolio level on portfolios containing significant
specific risk.
Ω Exceptions must be analysed. If the number of exceptions falls in the red zone for
any portfolio, immediate action must be taken to correct the model. The bank
must demonstrate that it is setting aside sufficient capital to cover extra risk not
captured by the model.
FSA and EBK regulations on the backtesting requirements to support specific risk
measurement follow the Basel Committee paper very closely.