Contrast external agency ratings with the rating systems that firms build in-house.
The idea
An agency rating is an opinion on creditworthiness published by firms such as S&P, Moody's and Fitch. Issuers pay for it, it covers mainly public debt issuers, and it is designed to be stable through the cycle, so agencies change a rating slowly and only when they judge the change to be lasting. Banks also build internal rating systems. These cover the unrated mid-size and private borrowers that agencies ignore, use private information such as financial statements, account behaviour and covenant compliance, and are usually closer to point-in-time, reacting quickly to current conditions. Under the Basel internal ratings approach a bank typically rates the obligor, which drives the probability of default, separately from the facility, which drives loss given default. The usual mistake is to treat the two kinds of rating as interchangeable. Through-the-cycle ratings barely move in a recession while point-in-time ratings migrate, and that changes how cyclical the capital requirement becomes.
A practice question
A bank's validation team describes an agency rating as a through-the-cycle rating. Which statement best describes what that means?
- The rating assesses creditworthiness over a long horizon across the whole business cycle, so it changes slowly and is not adjusted for temporary swings. - correct
- The rating is updated continuously to reflect the borrower's current financial condition and market prices.Why not: Describes a point-in-time rating, the opposite of through-the-cycle.
- The rating is set from the borrower's equity price alone, so it moves daily with the stock market.Why not: Confuses an agency rating with a market-based, equity-implied measure.
- The rating applies only to the facility's collateral and ignores the borrower's own repayment capacity.Why not: Confuses obligor ratings with facility-level (loss given default) ratings.
A through-the-cycle rating looks past temporary cyclical swings and changes only when the credit view changes lastingly; a point-in-time rating reflects current conditions and moves quickly.
A harder one
A risk manager must choose between agency ratings and an internal system for a loan book of 4,000 owner-managed companies, none of which has traded debt. What is the principal reason the internal system is the practical choice?
- Internal ratings are free of subjectivity because they are produced by a statistical model with no judgement.Why not: Internal systems often involve analyst judgement; they are not free of subjectivity.
- Internal ratings have decades of public default statistics that agencies have never collected.Why not: Reverses the facts: agencies publish long default histories, banks usually have shorter ones.
- Internal ratings are more stable through the cycle than agency ratings, which lowers regulatory capital.Why not: Internal systems tend to be more point-in-time, not more stable than agency ratings.
- Agencies do not rate most of these borrowers, and the bank can use private information such as financial statements, account behaviour and covenant compliance. - correct
The coverage gap and the access to private information are the key advantages of in-house ratings; their weaknesses are shorter default histories and possible subjectivity.
The hardest tier
A regulator worries about the procyclicality of capital requirements that depend on internal ratings. In a deep recession, which statement about capital requirements is correct?
- A point-in-time system downgrades many borrowers, raising capital requirements when capital is scarcest, while a through-the-cycle system raises them much less. - correct
- A through-the-cycle system raises requirements more, because its ratings are revised sharply once the downturn is confirmed.Why not: Reverses the two philosophies; through-the-cycle ratings are slow-moving.
- Both systems raise requirements equally, because the PD attached to each grade is identical across the two systems.Why not: Ignores that the systems differ in how fast borrowers migrate between grades.
- A point-in-time system lowers requirements, because current profits are measured against long-run averages.Why not: Misreads point-in-time: in a recession current conditions deteriorate, so downgrades raise requirements.
Point-in-time ratings migrate with the cycle, so more borrowers sit in higher-PD grades in a recession; through-the-cycle ratings change little, damping capital swings.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Estimating Default Probabilities
- Lay out how Altman's Z-score method works and put it to use in forecasting default for a firm and in sorting a set of firms into credit quality classes.
- Outline how a borrower's rating relates to its probability of default.
- Describe what a rating migration matrix is, and calculate the marginal, cumulative and ordinary probabilities of default from it.
- Introduce the hazard rate, then employ it to form probability functions for when default occurs and to derive default probabilities that are conditional as well as unconditional.
- Lay out what recovery rates are and how they move with default rates.
- State what a credit default swap (CDS) is and set out how it works, including what each of the protection buyer and the protection seller must do.
- Outline CDS spreads and show how they can serve to infer hazard rates.
- Define the CDS-bond basis and explain what it means.
- Set probabilities of default estimated from past experience beside those inferred from credit yield spreads, and weigh them against each other.
- Outline how real-world default probabilities differ from risk-neutral ones and decide which belongs in a given credit risk analysis.
- Use the Merton model to work out the value of a firm's debt and of its equity, together with the volatility of firm value and of firm equity.
- Use the Merton model to compute distance to default and the default probability.
- Assess the quality of default probabilities that come out of the Kamakura model, the Merton model and the Moody's KMV model.