Rating Validation Based on Shocks to Firms’ Credit Quality
31 Pages Posted: 3 Sep 2009 Last revised: 7 Feb 2012
Date Written: February 12, 2011
Abstract
This study suggests a new framework for validating issuer credit ratings as-signed by credit rating agencies (or any other type of rating system). Using a benchmark rating, based on publicly available information and high frequency market data, our framework builds on identifying severe (and permanent) shocks to firms' creditworthiness, particularly including financial distress. This provides a rich set of credit events which can be used to validate properties of credit ratings, because these shocks should lead to rating adjustments, even under a rating-through-the-cycle policy.
As an illustration, the framework is applied to assess the information sensitiv-ity of ratings by Standard & Poor's and the timeliness of their adjustments. We analyze instantaneous shocks, a financial status incompatible with being investment grade, and financial distress for a large sample of European com-panies from 2000-2010. S&P does not adjust its corporate rating in at least one third of all cases. Moreover, even if a rating change occurs, this happens typically at a lag of about four to six months. This insensitivity seems neither attributable to private information from monitoring nor to the rating-through-the-cycle approach employed by S&P.
Keywords: credit ratings, validation, rating , financial distress
JEL Classification: G14, G28, G33
Suggested Citation: Suggested Citation
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