11 March 2013

IMF Working Paper: Rating through-the-cycle - What does the concept imply for rating stability and accuracy?

Rating agencies generally assign ratings on a through-the-cycle basis, whereas banks' internal valuations are often based on a point-in-time performance, that is they are related to the current value of the rated entity's or instrument's underlying assets.

This paper compares the two approaches and assesses their impact on rating stability and accuracy. It finds that while through-the-cycle ratings are initially more stable, they are prone to rating cliff effects and also suffer from inferior performance in predicting future defaults. This is because they are typically smooth and delay rating changes. Using a through-the-crisis methodology that uses a more stringent stress test goes halfway toward mitigating cliff effects, but is still prone to discretionary rating change delays.  

The paper employs a simple structural credit risk model to compare two widely used rating methodologies. Specifically, the analysis compares the PIT and TTC rating approaches with regards to rating stability and accuracy. Results show that while TTC implied credit ratings are initially more stable, they are prone to rating cliff effects and suffer from an inferior ability to predict future defaults. Specifically, the problem inherent in the TTC approach relates to the fact that, in a second stage, ratings are typically smoothed and not adjusted immediately. The analysis has shown that this lagged reaction can potentially lead to rating cliff effects, i.e. initially stable ratings are prone to a sudden several notches rating downgrade.

Clearly, this abrupt change in the credit rating may lead to a market disruption and dangerous forced selling. When assessing the predictive power of the two rating approaches, one can observe a similar picture. While the PIT approach is always superior in forecasting future defaults, much of the superiority relates to the lagged reaction policy inherent in the TTC approach.

Summarising, this study has shown that the TTC approach has positive effects on rating stability from an ex-ante point of view, that is as long as the underlying stress scenario has not been breached. During this period, TTC ratings promote rating stability and are only slightly less accurate in predicting future defaults than the PIT approach.

However, once current ratings drop below those implied by the TTC approach, the TTC approach becomes prone to procyclical rating cliff effects and it suffers from a clearly inferior ability to predict future defaults. Current discussions on the usefulness of the TTC approach should therefore focus on the reaction to new information once the lower asset value, related to the initial stress scenario, is reached. The implementation of a "through the crisis" approach which has been mentioned by the CRAs themselves, seems to require a more severe stress test ex-ante, but it currently does not address the slow adjustment typically taking place once the cushion built in by a TTC approach is eroded nor the potential cliff effects due to an inefficient smoothing policy.

Full paper

© International Monetary Fund