An empirical comparison of default risk forecasts from alternative credit rating philosophies

Abstract

The New Basel Capital Accord will allow the determination of banks' regulatory capital requirements due to probabilities of default which are estimated and forecasted from internal ratings. Broadly, two rating philosophies are distinguished: Through the Cycle versus Point in Time Ratings. We employ a Likelihood-Ratio backtesting of both types with respect to their probability of default forecasts and correlations derived from a nonlinear random effects panel model using data from Standard & Poor's. The implications for risk capital using these different philosophies are demonstrated. It is shown that Point in Time Ratings will exhibit much lower correlations and, thus, default probability forecasts should be more precise. As a consequence, Value at Risk quantiles of default distributions should be lower than those generated by Through the Cycle Ratings. Nevertheless banks which use Point in Time Ratings may be punished in times of economic stress if the implied reduction of asset correlation is not taken into account.

Procyclicality in Basel II: Can we treat the disease without killing the patient?

“…While this argument has merit, it ought to apply equally to the bank's internal economic capital calculations. At least for large international institutions, franchise value at the horizon is dependent on 12 The IRB formula does embed a conservative estimate of the asset-correlation ρ relative to econometric estimates using rating agency performance data (Gordy and Heitfield 2002, Düllmann and Scheule 2003, Rösch 2003. This could cause the IRB formula at a 99.9% target to overshoot economic capital at higher target solvency probabilities in some internal systems.…”

Estimation of rating class transition probabilities with incomplete data

“…Since observing rating volatility, business cycle dependence and relatively frequent rating reversals is evidence of a point-in-time rating system, this paper finds that internal ratings are more point-in-time than external ratings (see Rö sch, 2005, for a discussion of the two rating philosophies).…”

Re-Mapping Credit Ratings

“…On the one hand, ratings differ across raters with respect to a) the underlying measure of creditworthiness (e.g., pure PD estimates vs. expected-loss (EL) estimates), b) the time horizon (e.g., long-term vs. short-term rating), c) the rating philosophy (e.g., point in time vs. through the cycle) and d) the granularity employed in the assessment (e.g., with vs. without modifiers) (BIS, 2006;Elkhoury, 2008;Rösch, 2005).…”