The impact of downward rating momentum on credit portfolio risk

Rating downgrades are known to make subsequent downgrades more likely. We analyze theimpact of this ‘downward momentum’ on credit portfolio risk. Using S&P ratings from 1996to 2005, we estimate a transition matrix that is insensitive to and a second matrix that is sensitiveto previous downgrades. We then derive differences between the insensitive portfolioValue-at-Risk (VaR) and the momentum-sensitive VaR. We find realistic scenarios whereinvestors who rely on insensitive transition matrices underestimate the VaR by eight percentof the correct value. The result is relevant for risk managers and regulators since banks neglectingthe downward rating momentum might hold insufficient capital.[...]