Rating philosophy and dynamic properties of internal rating systems: a general framework and an application to backtesting

Marco Morone, Anna Cornaglia

Abstract

ABSTRACT

This paper describes a general framework for asset and default dynamics, separating the influence of the economic cycle into a component that is embedded in the rating system and an unobservable risk factor that determines the movements of defaults around the ex ante estimated probabilities of default. The two components - the sensitivity of ratings to credit cycle and conditional asset correlation - can be quantified through a maximum likelihood approach, giving a measure of the cyclicality of the rating system, and allowing for a number of applications, among them the modified binomial test proposed here.