Contrast ratings built on a point-in-time basis with those built through the cycle, and explain each.
The idea
A point-in-time rating uses all currently available information, so it reflects the borrower's condition today and the current phase of the cycle. Ratings move up and down with the cycle, and the default probability attached to a grade stays fairly constant over time. A through-the-cycle rating looks past temporary cyclical conditions and assesses the borrower as it would be across a full cycle, often under stressed conditions. Ratings are stable and migrate less, but the realized default rate for a given grade rises in recessions and falls in expansions. Agency ratings are generally described as through the cycle, while internal ratings are more often point in time. Point-in-time systems make capital requirements more procyclical. The exam trap is to attach stability to the wrong thing. PIT has a stable default probability per grade, and TTC has stable grades.
A practice question
Which feature is characteristic of a point-in-time rating system?
- Borrowers migrate to lower grades in a downturn, while each grade's default probability stays steady. - correct
- Borrowers stay in the same grade through the cycle, while default rates within grades rise in a downturn.Why not: This describes a through-the-cycle system, where grades are stable and realized default rates per grade vary.
- Ratings are based mostly on the long-run average default rate of the industry, ignoring the borrower's latest results.Why not: Describes a through-the-cycle philosophy that disregards short-term information.
- Ratings change only when an agency committee meets, normally once a year.Why not: Describes infrequent review, which is typical of agency practice rather than the point-in-time approach.
In a PIT system the rating moves with current conditions, so the PD per grade is stable but the grade distribution shifts. In TTC the reverse holds.
A harder one
During a severe recession a borrower's earnings drop sharply, but the borrower is expected to recover when the economy does. Compared with a through-the-cycle rating, a point-in-time rating for this borrower is most likely to be:
- higher, because it already assumes the economy will recover.Why not: Describes the through-the-cycle viewpoint; a point-in-time rating weights current conditions most.
- the same, because both approaches use identical information and horizons.Why not: Ignores that the two approaches use different information sets and horizons; they diverge in a downturn.
- unrated, because a point-in-time rating cannot be assigned in a recession.Why not: Invents a restriction; PIT ratings are assigned in every phase of the cycle.
- lower, because it reflects the current deterioration. - correct
Point-in-time ratings respond to current conditions and so fall in a recession. Through-the-cycle ratings smooth over the temporary dip.
The hardest tier
A bank tracks its book over a business cycle. In a recession its observed default rates within each grade rise sharply, but the share of borrowers in each grade barely changes. The bank's rating system is most likely:
- point in time, since observed default rates per grade vary with the cycle.Why not: Reverses the logic: in a PIT system the PD per grade is stable and borrowers migrate between grades.
- through the cycle, since grades are stable while realized defaults per grade vary. - correct
- point in time, since a stable grade distribution means all current information is being used.Why not: A stable grade distribution through a recession points to ratings that ignore cyclical information, which is the TTC feature.
- neither, because any system with fixed grades will show rising default rates in a recession.Why not: Ignores that a PIT system adjusts grades so its PD per grade does not rise in the same way.
Stable grade membership with cyclical default rates per grade is the signature of a through-the-cycle system. A PIT system would show migration to weaker grades and a steady PD per grade.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in External and Internal Credit Ratings
- Describe the scales used by external rating agencies, how ratings are assigned, and how a rating connects to the chance of default.
- Distinguish default probabilities that are conditional from those that are unconditional, defining each.
- Define the hazard rate, then apply it to find the unconditional probability that a credit asset defaults.
- Define the recovery rate and, with it, compute the loan's expected loss.
- Outline the options that can be used in place of the credit ratings issued by rating agencies.
- Weigh internal ratings against external ones, noting the strengths of each.
- Describe a rating transition matrix, calculate with it, interpret it, and explain what it is used for.
- Outline how credit default swap spreads, bond prices and stock prices tend to move when a credit rating is upgraded or downgraded.
- Explain where credit ratings have failed in the past and what difficulties arise when they are relied on for investment decisions.