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Rating Philosophy and Dynamic Properties of Internal Rating Systems: A general framework and an application to backtesting

by Marco Morone of Intesa Sanpaolo, and
Anna Cornaglia of Intesa Sanpaolo

January 23, 2009

Abstract: The paper draws a general framework for asset and default dynamics, separating the influence of the economic cycle into a component which is embedded in the rating system and an unobservable risk factor that determines the movements of defaults around the ex ante estimated PDs. 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 those the modified binomial test proposed here.

JEL Classification: C15, C13, G32.

Keywords: rating philosophy, rating dynamics, cyclicality, asset correlation, migration matrices, ML estimation, backtesting, binomial test.

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