Credit Cycle Stress Testing Using a Point-in-Time Rating System

Sean Keenan, David Li, Stefano Santilli, Andrew Barnes, Kete Chalermkraivuth and Radu Neagu

Managers and supervisors of financial institutions recognise two different approaches to internal credit rating systems: through-the-cycle (TTC) and point-in-time (PIT). In simple terms, a PIT system is one in which rating grades are associated with fixed probabilities of default (PD) that should obtain, approximately, in every period. Credit cycles should not affect the observed default rate’s rating grades. Changes in the credit quality of obligors should be captured entirely through rating changes, not through variances in observed default rates by grade. Through-the-cycle systems seek to assign ratings that are stable over changing credit cycle conditions, preserving the relative rank ordering of risk across obligors and allowing the absolute level of default risk to vary (see Lewis 2004). While many articles debate the relative merits of these approaches (see, for example, Heitfield (2004) or Gordy and Howells (2004)) there is little doubt that a commitment to a PIT system presents institutions with some specific challenges and benefits.

One significant challenge stems from the fact that PIT PD models are voracious consumers of timely data. Where daily stock prices are