HONG KONG, 25 November 2020. Pengyuan International has released one research report, “Evaluating the Performance of Credit Ratings Using Default Data and Quantitative Measures”.
A credit rating is a forward-looking analytical opinion on an obligor or obligation’s overall creditworthiness, based on the principles of independence, objectivity and impartiality. It mainly focuses on the obligor’s willingness and capacity to fulfill its financial commitments. As one of the infrastructures in the bond market, credit ratings play an important role in revealing credit risks, assisting market pricing and improving market efficiency. However, a credit rating will be effective only if its performance has been validated and accepted by market participants. To improve the quality and recognition of credit ratings, a set of validation techniques should be established to provide reasonable performance measures for credit ratings.
Credit spread significance test is a commonly used validation tool of credit ratings performance in China, mainly due to an absence of historical default data in China's bond market. Data unavailability makes it infeasible to directly evaluate the performance of credit ratings using default data. Moreover, defects are observed in both hypothesis and accuracy of the test. In order to validate the credit ratings performance accurately, the market needs a set of reliable validation techniques and measures which can directly reflect the accuracy of credit risk measurement. Given the accumulation of default data in China’s bond market in recent years, the quantitative method using default data to evaluate the performance of credit ratings should be implemented more widely.
This research introduces a systemic approach to quantitatively assess the performance of credit ratings, which is built upon the evaluation methods wildly applied in other major markets. This approach provides diversified and effective tools for credit rating agencies (CRAs), investors, originators and regulators. Our quantitative validation system consists of three dimensions—discriminatory power, predictive accuracy and rating stability.
· The discriminatory power of a methodology relates to its ability to rank-order the rated entities in accordance with their future status (defaulted or not defaulted) at a predefined time horizon. Three indicators are introduced to demonstrate the discriminatory power, including Area Under the Receiver Operating Characteristic Curve (AUROC), Accuracy Ratio (AR) and Kolmogorov-Smirnov (K-S) Statistic.
· The predictive accuracy measures whether the credit rating methodology can predict the default rate in respect to each rating category accurately, which can be demonstrated by comparing the expected default rates of the credit ratings to the observed results. Statistical hypothesis tests, especially binomial test, Chi-square test and normal test, are the commonly used tools to conduct the validation.
· The rating stability assesses the stability of the credit ratings, the stability of the characteristics of the rated entities or instruments and the distribution of the assigned credit ratings. Transition (migration) matrices, the movement of the credit rating (e.g., frequency and magnitude of the upgrades and downgrades), and Population Stability Index (PSI) are used to demonstrate the rating stability.
The constructed quantitative approach is then adopted to validate the corporate rating methodologies of seven Chinese CARs.
In terms of the assessment of the discriminatory power, we measure the ability to rank-order the rated entities in accordance with their future status in the span of one year. The results of AUROC, AR and K-S statistic show that China Bond Rating, CSCI Pengyuan and China Chengxin International Credit Rating (CCXI) perform well.
In the assessment of predictive accuracy, we observe whether the one-year average default rate with respect to each rating category is consistent with our expectation. The results show that the three credit rating agencies with good prediction accuracy are China Bond Rating, CCXI and CSCI Pengyuan.
In the assessment of rating stability, we construct transition matrices and calculate the frequency and magnitude of the upgrades and downgrades. The results show that the three credit rating agencies with high rating stability are CSCI Pengyuan, CCXI and Golden Credit Rating.
Note: This press release is a translation of the original in Chinese. If there is any inconsistency or ambiguity between these two versions, the Chinese original will prevail.
Date of Relevant Research Committee: 23 November 2020
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