A Theory of Credit Rating Criteria
54 Pages Posted: 1 Jan 2020 Last revised: 7 Dec 2021
Date Written: December 6, 2021
We propose a theory for rating financial securities based on a concept of self-consistency, which does not allow issuers to gain, by tranching financial securities and structural maximization, from investors who rely on the rating criterion for pricing. While the expected loss criterion used by Moody's satisfies self-consistency, the probability of default criterion used by S\&P does not. Empirical evidences in the post-Dodd-Frank period are consistent with the theoretical implication. We show that a set of axioms based on self-consistency leads a tractable representation for all self-consistent rating criteria, which can also be extended to incorporate economic scenarios. New examples of self-consistent and scenario-based rating criteria are suggested.
Keywords: Credit ratings, Structured finance, Dodd-Frank, Axiomatic characterization
JEL Classification: G12
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