Backtesting exception KPI
Basel Committee introduced a framework for the supervisory interpretation of financial institutions’ backtesting results. It defines the three zones (Green, Yellow, and Red) by identifying the starting points of the Yellow and the Red zone. The Yellow Zone begins at the point such that the probability of obtaining that number or fewer exceptions equals or exceeds 95%, the Red Zone begins at the point such that the probability of obtaining that number or fewer of exceptions equals or exceeds 99.99%.
With those definitions, it then proceeds to define the three zones for the 1-year worth of backtesting results (250-days) at the 99% confidence level (i.e. the level at which the VaR risk measure is normally calculated).
We outline in more details the methodology that is implicitly employed to define the three zones and then indicate how to extend it to more cases (different time horizons and confidence levels). Note that currently the backtesting is performed in VaR as part of everyday model performance monitoring. We show below backtesting results, for total VaR and GMR VaR (general market risk VaR), for the one year period.
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