Rating Through-the-Cycle: What does the Concept Imply for Rating Stability and Accuracy?

IMF Working Papers, March 8, 2013

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Credit rating agencies face a trade-off between delivering accurate ratings and delivering stable ratings.
Users consistently express a preference for rating stability because of transactions costs induced by trading when ratings change frequently.
Rating agencies generally assign ratings on a through-the-cycle (TTC) basis.
Banks' internal valuations are often based on a point-in-time (PIT) performance, related to the current value of the rated entity's or instrument's underlying assets.
The paper compares TTC and PIT approaches and assesses their impact on rating stability and accuracy.

Through-the-cycle ratings are initially more stable than point-in-time valuations.
Through-the-cycle ratings are prone to rating cliff effects.
Through-the-cycle ratings suffer from inferior performance in predicting future defaults relative to approaches that capture point-in-time information.
The inferior predictive performance is attributed to TTC ratings typically being smooth and delaying rating changes.
A "through-the-crisis" methodology that uses a more stringent stress test partially mitigates cliff effects but remains prone to discretionary rating change delays.

Comparison centers on the behavioral properties of TTC ratings (smoothing, delay) versus PIT valuations (current-value sensitivity).
The "through-the-crisis" methodology represents an adjustment to TTC that increases stress testing stringency; it reduces but does not eliminate drawbacks associated with delayed rating adjustments.

Preference for stability (driven by trading costs) must be weighed against reduced default-prediction accuracy when adopting TTC ratings.
Reliance on TTC ratings can create cliff effects that may induce abrupt market reactions when delayed rating changes occur.
Strengthening stress-testing within TTC frameworks (a through-the-crisis approach) can attenuate cliff effects but does not fully resolve discretionary delays in rating changes.
Users and regulators should consider the trade-offs between stability and timeliness/accuracy when setting expectations or rules that rely on external ratings.

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