Biased benchmarks

ABSTRACT Regulators and credit analysts have used long-run average default rates (DRs) from Standard & Poor's (S&P) and Moody's default studies and expected default frequencies (EDFs) from the Moody's KMV (MKMV) public firm model as benchmarks for evaluating the accuracy of an institution's probability of default models. But recent evidence indicates that, over the last eleven years, these benchmarks have been exaggerating default risk for nonfinancial, corporate entities ("corps"). For corps, over the 2003-13 cyclically neutral period, the average one-year realized DRs of almost every S&P or Moody's alphanumeric grade are well below the average DRs experienced before 2003. Expressed in terms of grades, it appears that over the 2003-13 time period both S&P and Moody's have been grading corps more harshly than earlier, by about one alphanumeric notch in the speculative-grade range and by about two in the investment-grade range. For financial institutions (FIs), recent overestimation of default risk occurs only in the subinvestment grades. Reflecting the catastrophic failures of some highly rated institutions during 2008-9, the DRs in the low-risk grades equivalent to S&P A+ or better were moderately higher than before 2003. We find patterns similar to these with MKMV EDFs, except that for FIs the overestimation is more pervasive than with S&P and Moody's grades. The source of this time inconsistency bias remains unclear. It could be due to unidentified improvements in risk management (especially in corps) or due to the growing asymmetry in the attitudes of regulators and others toward under- and overestimation of risk. The evidence presented here raises concerns that lending institutions applying these benchmarks may be unduly restricting corporate lending.