Skip to main content

Are Ratings the Worst Form of Credit Assessment Except for All the Others?

  • Andreas Blöchlinger and Markus Leippold

We present a prediction model to forecast corporate defaults. In a theoretical model, under incomplete information in a market with publicly traded equity, we show that our approach must outperform ratings, Altman’s Z-score, and Merton’s distance to default. We reconcile the statistical and structural approaches under a common framework; that is, our approach nests Altman’s and Merton’s approaches as special cases. Empirically, the combined approach is indeed the most powerful predictor, and the numbers of observed defaults align well with the estimated probabilities. With a new transformation method, we obtain cycle-adjusted forecasts that still outperform ratings.

Corresponding author
* Blöchlinger,, Zurich Cantonal Bank and University of Zurich; Leippold (corresponding author),, University of Zurich Department of Banking and Finance and Swiss Finance Institute.
Hide All

We thank an anonymous referee, Karan Bhanot, Peter Christoffersen, Sergei Davydenko, Jin-Chuan Duan, Michael Gordy, Jarrad Harford (the editor), Harald Hau, Liuren Wu, and participants at the 2012 European Finance Association Conference, the 2013 Risk Management Conference, the 2014 Quant Europe Conference, and finance seminars at the University of Zurich, and the University of Toronto for useful comments. We thank Basile Maire for augmenting and arranging the data set used for our empirical analysis. The content of this article reflects the personal view of the authors. In particular, it does not necessarily represent the opinion of the Zurich Cantonal Bank. Leippold gratefully acknowledges financial support from the Swiss Finance Institute (SFI) and Bank Vontobel.

Hide All
Agarwal V., and Taffler R. J.. “Comparing the Performance of Market-Based and Accounting-Based Bankruptcy Prediction Models.” Journal of Banking and Finance, 32 (2008), 15411551.
Akaike H.A New Look at the Statistical Model Identification.” IEEE Transactions on Automatic Control, 19 (1974), 716723.
Alp A.Structural Shifts in Credit Rating Standards.” Journal of Finance, 68 (2013), 24352470.
Altman E. I.Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy.” Journal of Finance, 23 (1968), 589609.
Altman E. I.; Haldeman R. G.; and Narayanan P.. “ZETA Analysis: A New Model to Identify Bankruptcy Risk of Corporations.” Journal of Banking and Finance, 1 (1977), 2954.
Altman E. I., and Rijken H. A.. “A Point-in-Time Perspective on Through-the-Cycle Ratings.” Financial Analysts Journal, 62 (2006), 5470.
Bharath S. T., and Shumway T.. “Forecasting Default with the KMV-Merton Model.” Discussion Paper, AFA 2006 Boston Meetings Paper (2006).
Bharath S. T., and Shumway T.. “Forecasting Default with the Merton Distance to Default Model.” Review of Financial Studies, 21 (2008), 13391369.
Blöchlinger A.Validation of Default Probabilities.” Journal of Financial and Quantitative Analysis, 47 (2012), 10891123.
Blöchlinger A., and Leippold M.. “Economic Benefit of Powerful Credit Scoring.” Journal of Banking and Finance, 30 (2006), 851873.
Blöchlinger A., and Leippold M.. “A New Goodness-of-Fit Test for Event Forecasting and Its Application to Credit Defaults.” Management Science, 57 (2011), 471486.
Campbell J.; Hilscher J.; and Szilagyi J.. “In Search of Distress Risk.” Journal of Finance, 63 (2008), 28992939.
Cantor R., and Mann C.. “Special Comment: Measuring the Performance of Corporate Bond Ratings.” Moody’s Investors Service (Apr. 2003).
Cantor R., and Mann C.. “Analyzing the Tradeoff between Ratings Accuracy and Stability.” Journal of Fixed Income, 16 (2007), 6068.
Chava S., and Jarrow R.. “Bankruptcy Prediction with Industry Effects.” Review of Finance, 8 (2004), 537569.
Crosbie P., and Bohn J.. “Modeling Default Risk.” Moody’s KMV (2003).
Das S.; Duffie D.; Kapadia N.; and Saita L.. “Common Failings: How Corporate Defaults Are Correlated.” Journal of Finance, 62 (2007), 93117.
Deventer D. R.; Li L.; and Wang X.. “Advanced Credit Model Performance Testing to Meet Basel Requirements.” In The Basel Handbook: A Guide for Financial Practitioners, Ong M. K., ed. London, UK: Risk Books (2005).
Ding A.; Tian S.; Yu Y.; and Guo H.. “A Class of Discrete Transformation Survival Models with Application to Default Probability Prediction.” Journal of the American Statistical Association, 107 (2012), 9901003.
Duan J. C.; Sun J.; and Wang T.. “Multiperiod Corporate Default Prediction: A Forward Intensity Approach.” Journal of Econometrics, 170 (2012), 191209.
Duffie D., and Lando D.. “Term Structures of Credit Spreads with Incomplete Accounting Information.” Econometrica, 69 (2001), 633664.
Duffie D.; Saita L.; and Wang K.. “Multi-Period Corporate Default Prediction with Stochastic Covariates.” Journal of Financial Economics, 83 (2007), 635665.
Fama E. F., and French K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 356.
Fink R.Where Credit Is Due.” CFO Magazine (Nov. 2003).
Galil K.“The Quality of Corporate Credit Rating: An Empirical Investigation.” EFMA 2003 Helsinki Meetings Paper (2003).
Hamilton J. D. Time Series Analysis. Princeton, NJ: Princeton University Press (1994).
Hillegeist S.; Keating E.; Cram D.; and Lundstedt K.. “Assessing the Probability of Bankruptcy.” Review of Accounting Studies, 9 (2004), 534.
Hilscher J., and Wilson M. I.. “Credit Ratings and Credit Risk.” Working Paper, Brandeis University and Oxford University (2012).
Hilscher J., and Wilson M. I.. “Credit Ratings and Credit Risk: Is One Measure Enough?Management Science, 63 (2017), 34143437.
Hosmer D. W.; Hosmer T.; le Cessie S.; and Lemeshow S.. “A Comparison of Goodness-of-Fit Tests for the Logistic Regression Model.” Statistics in Medicine, 16 (1997), 965980.
Kane G. D., and Meade N. L.. “Ratio Analysis Using Rank Transformation.” Review of Quantitative Finance and Accounting, 10 (1998), 5974.
Kane G. D.; Richardson F. M.; and Meade N. L.. “Rank Transformations and the Prediction of Corporate Failure.” Contemporary Accounting Research, 15 (1998), 145166.
Kiff J.; Kisser M.; and Schumacher L.. “Rating Through-the-Cycle: What Does the Concept Imply for Rating Stability and Accuracy?” International Monetary Fund Working Paper 13-64 (2013).
Lando D., and Nielsen M. S.. “Correlation in Corporate Defaults: Contagion or Conditional Independence?Journal of Financial Intermediation, 19 (2010), 355372.
Lorenz M. O.Methods of Measuring the Concentration of Wealth.” Publications of the American Statistical Association, 9 (1905), 209219.
Maddala G. S. Limited-Dependent and Qualitative Variables in Econometrics. Cambridge, UK: Cambridge University Press (1983).
Merton R. C.On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance, 29 (1974), 449470.
Shumway T.Forecasting Bankruptcy More Accurately: A Simple Hazard Model.” Journal of Business, 74 (2001), 101124.
Spearman C.The Proof and Measurement of Association between Two Things.” American Journal of Psychology, 15 (1904), 88103.
Stein R.The Relationship between Default Prediction and Lending Profits: Integrating ROC Analysis and Loan Pricing.” Journal of Banking and Finance, 29 (2005), 12131236.
The Economist. “Undue Credit.” The Economist (May 30, 2015).
Vassalou M., and Xing Y.. “Default Risk in Equity Returns.” Journal of Finance, 59 (2004), 831868.
Recommend this journal

Email your librarian or administrator to recommend adding this journal to your organisation's collection.

Journal of Financial and Quantitative Analysis
  • ISSN: 0022-1090
  • EISSN: 1756-6916
  • URL: /core/journals/journal-of-financial-and-quantitative-analysis
Please enter your name
Please enter a valid email address
Who would you like to send this to? *


Full text views

Total number of HTML views: 0
Total number of PDF views: 25 *
Loading metrics...

Abstract views

Total abstract views: 116 *
Loading metrics...

* Views captured on Cambridge Core between 16th January 2018 - 18th February 2018. This data will be updated every 24 hours.