On the Negative Correlation between Default Rates and the Discriminatory Power of Credit Ratings

Financial institutions and rating agencies routinely monitor the discriminatory power of credit ratings so that potential weaknesses are detected early. This article presents an empirical study, that shows that the higher the level of default rates, the lower the expected discriminatory power of ratings. A simulation study provides benchmarks for the empirical results and thus the theoretical foundation of the connection. The findings show that not only is the variation of the discriminatory power of credit ratings driven by the random nature of defaults but that there is additionally a systematic effect present that is caused by the correlation between the expected discriminatory power and the level of default rates