Testing for Rating Consistency in Annual Default Rates

Abstract

We examine issues in testing whether default rates by credit rating categories are consistent across sectors or consistent over time. Our main findings are that sector and macroeconomic shocks inflate the sample standard deviations, compared to using a simple binomial default probability, and we provide a closed form solution that addresses this problem. We apply these results to two well-known cases: testing rating consistency across regions (U.S. versus non-U.S. companies) and across industries (banks versus nonbanks).