Credit Ratings are Not Reliable in Predicting Corporate Failure

Agencies which provide credit ratings have played very significant roles in the financial markets. In fact, some of their decisions which are not accurate had made headlines in the business news. There are industry experts and regulators who are questioning the reliability and the use of credit rating agencies according to research conducted.

According to Dr. Mungo Wilson, a Lecturer in Financial Economics at University of Oxford, the research they conducted simply proves the truth about the negative comments that the critics have been arguing for many years about the wrong information provided by credit rating agencies. The ratings made by credit agencies are a poor predictor of default probability. It is because the explanation is not very clear about the default probability. Many variations have to be considered in default probabilities and in addition to this the empirical failure rate in the business cycle must be accurately recorded.

Credit ratings are still the instrument widely used to measure the corporate credit quality. And this is being challenged by a paper from Dr. Wilson and Jens Hilscher, Assistant Professor of Finance at Brandeis University.

The paper shows that the information included in the corporate credit ratings are poor predictor of default probability. Dr. Wilson and Jens said that based on their study and research, a simple model which gathers publicly available information which is called ‘failure score’ is a better and more reliable means of predicting default risk. They used data from 1986 to 2008 and compared it with the prediction made by Standard and Poor’s corporate credit ratings and they found out that their method is twice as effective as that of Standard and Poor’s method.

The data gathered demonstrate that firms have the tendency to default in bad times and which may be referred as systematic defaults risk. The data also suggest insight to corporation owners on how they will fare during economic crisis. Dr. Wilson and Jens observed that credit rating agencies merely based their ratings through the cycle instead of considering the effect of the business cycle fluctuations on default probability. This is the reason why their ratings are not reliable and are poor predictors of default.

The researchers made a conclusion that in order to get an accurate measure of default prediction it should be separated from systematic risk. Default prediction data could quickly respond to specific news while systematic risk’s measure could be a mix of aggregate credit conditions and current credit ratings.

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