Myth and Reality of Discriminatory Power for Rating Systems

by Stefan Blochwitz of Deutsche Bundesbank,
Alfred Hamerle of the University of Regensburg,
Stefan Hohl of the Bank for International Settlements,
Robert Rauhmeier of KfW-Bankengruppe, and
Daniel Rösch of the University of Regensburg

July 27, 2004

Abstract: Under the Revised International Capital Framework, debtors’ credit ratings and probabilities of default in credit portfolios have a key role in determining minimum regulatory capital requirements. To measure discriminatory power of rating systems, methods such as the area under a ROC curve, the Accuracy Ratio and PowerStat are often used both in academic studies and in practice. This paper shows that these measures need to be interpreted with caution since their values hinge crucially on the characteristics of the portfolio under consideration and not just on the quality of the rating system.

Published in: Wilmott Magazine, No. 15, (January 2005), pp. 2-6.

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