Can Credit Risk Be Rated Through-the-Cycle?

50 Pages Posted: 29 Jun 2012

Date Written: April 1, 2012

Abstract

Since the introduction of Basel II, it has been argued that the use of internal credit risk models in banks may strengthen the procyclicality of the financial system. This problem could be alleviated by using through-the-cycle (TTC) ratings. A TTC rating ignores cyclical fluctuations of credit risk. The existence of transitory cyclical fluctuations in corporate credit risk at the company level in Moody’s KMV data on Finnish publicly listed companies is tested. The evidence is mostly negative. The distance-to-default of a typical company seems to follow a unit root process. In most cases company level credit risk does not follow cycles with a predictable regularity, and companies that suffered most from the previous downturn may not benefit particularly strongly from the following upturn. Due to continuous entry and exit of firms, average credit risk can be stationary even if the distance-to-default of each individual company is a unit root process.

Keywords: Through-the-cycle rating, Credit risk, Distance to default, Procyclicality

JEL Classification: E44, G21, G33

Suggested Citation

Kauko, Karlo, Can Credit Risk Be Rated Through-the-Cycle? (April 1, 2012). Frontiers in Finance and Economics, Vol. 9, No. 1, 1-32, Available at SSRN: https://ssrn.com/abstract=2096123

Karlo Kauko (Contact Author)

Bank of Finland ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland

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