Estimating default probabilities with credit ratings

Moody's, S&P and Fitch provide ratings describing the creditworthiness of corporate bonds. Credit ratings are designed to change infrequently. Credit rating companies are careful to avoid rating reversals, and also try to take the business cycle into account when assigning ratings.

Banks also produce internal credit ratings. This is necessary since not all corporate bonds are covered by the rating agencies. The internal ratings based approach in Basel II allows banks to use their internal credit ratings when determining the probability of default. Those banks deemed sophisticated enough by regulators are also allowed to use internal measures of the loss given default, the exposure at default, and the maturity.

The Z-score is one internal credit rating method based on discriminant analysis on accounting ratios to assign default probabilities to corporate bonds.