Through‐the‐Cycle Ratings Versus Point‐in‐Time Ratings and Implications of the Mapping Between Both Rating Types

The two philosophies of ratings, one that includes cyclical effects and the other that doesn't, are mirrored by the two different rating types commonly known as point‐in‐time (pit) and through‐the‐cycle (ttc). Point‐in‐time ratings try to evaluate the current situation of a customer by taking into account both cyclical and permanent effects. In contrast, through the‐cycle ratings focus mainly on the permanent component of default risk and are nearly independent from cyclical changes in the creditworthiness of a customer. In this paper we give a review of the characteristics of both rating types and examine whether these properties can actually be observed in practice. In this context we present the results of an analysis of Standard& Poor's rating data, which show that the ratings, though being through‐the‐cycle, still vary in accordance with the business cycle. Another concern of this paper is the wide spread practice to map ‘external’ through‐the‐cycle ratings to ‘internal’ point‐in‐time ratings, with the purpose to enrich or validate a financial institution's internal rating database. We show that in doing so financial institutions severely misspecify customers' risk profiles and under‐ or overestimate costs in connection with credit pricing or capitalization. We confirm our theoretical considerations by calculating pricing quantities when using one or the other rating information.