Explain PD model validation steps
Overview
This question evaluates competency in PD model validation and credit risk analytics, covering data partitioning and leakage control, discrimination and calibration assessment, stability and drift monitoring, backtesting, challenger governance, and model risk documentation.
Validate a Newly Developed Probability of Default (PD) Model
Context
Assume you have built a retail credit Probability of Default (PD) model with a 12‑month default horizon using historical applications and realized default outcomes. You are asked to outline how you would validate this model before deployment and set up ongoing monitoring.
Task
Describe a practical, end‑to‑end validation plan that covers:
- Data partitioning and leakage control (including time-based splits and class imbalance handling).
- Discrimination metrics and interpretation (e.g., AUC/ROC, Gini, KS, PR‑AUC, lift).
- Calibration checks and fixes (e.g., Brier score, reliability curves, intercept/slope tests, Hosmer–Lemeshow, recalibration methods).
- Stability monitoring for drift (e.g., PSI/CSI, segmentation, thresholds, triggers).
- Backtesting against realized defaults over time (e.g., E/O by bands, statistical tests, vintages).
- Challenger models and champion–challenger governance.
- Documentation and controls for model risk management.
Be explicit about key assumptions, typical thresholds, common pitfalls, and how you would validate results statistically. Where helpful, include small numeric examples or formulas.
Solution
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