TAILIEUCHUNG - HOW RATING AGENCIES ACHIEVE RATING STABILITY

In the Basel II framework, external ratings are used for the purpose of enhancing the risk sensitivity of the framework, for example, by being incorporated into assessments of the credit quality of an exposure or creditworthiness of a counterparty – and thus the imposition of capital requirements. External ratings are primarily used under the standardised approach for credit risk, 10 but also to risk-weight securitisations exposures. The different uses of external ratings generally correspond to probability of default treatments under the standardised approaches, and to situations where the use of internally generated ratings is impossible or difficult given, for. | How rating agencies achieve rating stability Edward I. Altman1 and Herbert A. Rijken2 April 2004 JEL classification G20 G33 Keywords Rating agencies through-the-cycle rating methodology migration policy creditscoring models default prediction 1 NYU Salomon Center Leonard N. Stem School of Business New York University 44 West 4th Street New York NY 10012 USA. email ealtman@ 2 Vrije Universiteit Amsterdam De Boelelaan 1105 1081 HV Amsterdam The Netherlands email hrijken@ The authors wish to thank Richard Cantor Adrian Buckley an anonymous referee seminar participants at the University of Ulm and at the Vrije Universiteit Amsterdam and participants at the FMA-conference in Denver for their comments and suggestions on a previous version of the paper. Abstract Surveys on the use of agency credit ratings reveal that some investors believe that rating agencies are relatively slow in adjusting their ratings. A well-accepted explanation for this perception on the timeliness of ratings is the through-the-cycle methodology that agencies use. According to Moody s through-the-cycle ratings are stable because they are intended to measure the risk of default risk over long investment horizons and because they are changed only when agencies are confident that observed changes in a company s risk profile are likely to be permanent. To verify this explanation we quantify the impact of the long-term default horizon and the prudent migration policy on rating stability from the perspective of an investor - with no desire for rating stability. This is done by benchmarking agency ratings with a financial ratio-based credit scoring agency-rating prediction model and credit scoring default-prediction models of various time horizons. We also examine rating migration practices. Final result is a better quantitative understanding of the through-the-cycle methodology. By varying the time horizon in the estimation of default-prediction models we search for a best match .

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