Rating validation based on shocks to firms´ credit quality
This study suggests a new framework for validating issuer credit ratings assigned by credit rating agencies. Using a benchmark rating, based on publicly available information and high frequency market data, our framework builds on identifying severe (and permanent) shocks to firms' creditworthiness, particularly including financial distress. This leads to a rich data set of credit events which can be used to validate properties of credit ratings, because these shocks should lead to rating adjustments, even under a rating-through-the-cycle policy. As an illustration, the framework is applied to assess the information sensitivity of ratings by Standard & Poor's, and the timeliness of their adjustments. We analyze instantaneous shocks, a financial status incompatible with being investment grade, and financial distress for a large sample of European companies from 2000-2010. S&P does not adjust its corporate rating in at least one third of all cases. Moreover, even if a rating change occurs, this happens typically at a lag of about four to six months. This insensitivity seems neither attributable to private information from monitoring nor to the rating-through-the-cycle approach employed by S&P.