Rating Validation Based on Shocks to Firms’ Credit Quality

31 Pages Posted: 3 Sep 2009 Last revised: 7 Feb 2012

See all articles by Ralf Elsas

Ralf Elsas

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management)

Sabine Mielert

affiliation not provided to SSRN

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

Elsas, Ralf and Mielert, Sabine, Rating Validation Based on Shocks to Firms’ Credit Quality (February 12, 2011). Available at SSRN: https://ssrn.com/abstract=1466710 or http://dx.doi.org/10.2139/ssrn.1466710

Ralf Elsas (Contact Author)

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management) ( email )

Kaulbachstr. 45
Munich, DE 80539
Germany

Sabine Mielert

affiliation not provided to SSRN ( email )

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