The Informational Content of Credit Ratings,and Cyclical Patterns of Default Rates

With the New Basle Capital Accord banks’ capital requirements are determined with risk weights based on internaland external ratings and probabilities of default (PD’s). PD’s are mostly estimated from historical defaultrates. In recent working papers the Basle Committee on Banking Supervision states that these default rates oftenexhibit a cyclical pattern roughly consistent with the credit cycle. This raises the question concerning when defaultrates vary or when they are constant through time since their cyclical pattern has an immediate impact onthe estimated default probabilities. A sample portfolio of borrowers is constructed and it is shown that defaultrates vary depending on the information which is incorporated in the underlying rating system. It turns out thatdefault rates which are produced by rating systems using all information...