An Empirical Comparison of Default Risk Forecastsfrom Alternative Credit Rating Philosophies

The New Basel Capital Accord will allow the determination of banks’ regulatory capital requirementsdue to probabilities of default which are estimated and forecasted from internal ratings.Broadly, two rating philosophies are distinguished: Through the Cycle versus Point inTime Ratings. We employ a Likelihood-Ratio backtesting of both types with respect to theirprobability of default forecasts and correlations derived from a nonlinear random effects panelmodel using data from Standard & Poor’s. The implications for risk capital using these differentphilosophies are demonstrated. It is shown that Point in Time Ratings will exhibit much lowercorrelations and, thus, default probability forecasts should be more precise. As a consequence,Value at Risk quantiles of default distributions should be lower than...