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 internal and external ratings and probabilities of default (PDs). PDs are mostly estimated from historical default rates. In recent working papers the Basle Committee on Banking Supervision states that these default rates often exhibit a cyclical pattern roughly consistent with the credit cycle. This raises the question concerning when default rates vary or when they are constant through time since their cyclical pattern has an immediate impact on the estimated default probabilities. A sample portfolio of borrowers is constructed and it is shown that default rates vary depending on the information which is incorporated in the underlying rating system. It turns out that default rates which are produced by rating systems using all information which influences default risk are approximately constant through time, whereas default rates produced by rating systems which omit relevant information will exhibit cyclical patterns. Transition matrices should change with the credit cycle if the rating captures all information which is relevant for default risk.