How rating Agenices achieve rating stability

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 with the agency-rating prediction model. Consistent with the agencies' stated objectives, we conclude that agency ratings are focused on the long term. In contrast to one-year default prediction models, agency ratings place less weight on short-term indicators of credit quality. We also demonstrate that the focus of agencies on long investment horizons explains only part of the relative stability of agency ratings. The other aspect of through-the-cycle rating methodology - agency rating-migration policy - is an even more important factor underlying the stability of agency ratings. We find that rating migrations are triggered when the difference between the actual agency rating and the model predicted rating exceeds a certain threshold level. When rating migrations are triggered, agencies adjust their ratings only partially, consistent with the known serial dependency of agency rating migrations.

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