Procyclicality of credit rating systems: How to manage it

Abstract

The recent Eurozone financial crisis has highlighted the need for stable rating systems to assess banks’ portfolio risks abstracting from the current cyclical conditions.This paper evaluates the characteristics of a Point in Time (PiT) rating approach for the estimation of firms’ credit risk in terms of procyclicality. To this end I first estimate a logit model for the probability default (PD) of a set of Italian non-financial firms during the period 2006–2012, then, in order to address the issue of rating stability (hedging against rating changes) during the financial crisis, I study the effectiveness of ex post smoothing of PDs in terms of obligors’ migration among rating risk grades. As a by-product I further discuss and analyse the role played by the choice of rating scale in producing ratings stability.The results show that ex post PD smoothing is able to remove business cycle effects on the credit risk estimates and to produce a mitigation of obligors’ migration among risk grades over time. The rating scale choice also has a significant impact on rating stability. These findings have important policy implications in banking sector practices in terms of the stability of the financial system.