Caveats for Associating Internal Rating Grades with Agency Rating PDs
7 Pages Posted: 8 Aug 2008
Date Written: August 7, 2008
It is common practice in banks to create internal ratings by approximating external ratings (e.g. by a rating agency) and then using this information to assign probabilities of default (PDs) to each grade by taking recourse to the external PDs. The validity of such a procedure is implicitly based on two assumptions:
1) The rating agency PDs are precise.
2) The closer the approximation of the agency ratings by the internal ratings is, the better the external agency PDs are as predictors of the internal PDs.
Whereas Assumption 1) is widely accepted for the length of the agencies default time series and the relatively small changes in their annual estimation updates, Assumption 2) so far appears to have drawn little attention by practitioners and regulators alike. By means of two stylized examples, we explore the meaning of Assumption 2). It turns that there can be systematic bias in PD estimates if external PD are uncritically adopted.
Keywords: Probability of default (PD), rating prediction, benchmarking, external rating
JEL Classification: G21, C13
Suggested Citation: Suggested Citation