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FRM Part II · FRM Exam Part II · Credit Scoring and Rating

A bank assigns obligors to rating grades using a through-the-cycle (TTC) philosophy. During a sharp recession, the portfolio's realized default rate rises well above the grade-level PD estimates, while the ratings of most obligors barely migrate. Which statement best describes this outcome?

This outcome is expected under a through-the-cycle philosophy. TTC ratings are stable and grade PDs reflect long-run average default rates, so realized defaults rise in recessions and fall in booms without much rating migration. Point-in-time ratings, by contrast, would migrate with conditions.

  1. AIt indicates the model is flawed because TTC ratings should move one-for-one with the cycle
  2. BIt is expected, because TTC ratings are stable across the cycle and realized default rates will fluctuate around long-run average PDsCorrect
  3. CIt shows the bank should use point-in-time PDs and ignore long-run averages for capital
  4. DIt means the grades are not differentiating risk at all

Explanation

TTC ratings are designed to be stable and reflect long-run, stressed-cycle-neutral risk, so grade PDs approximate long-run averages while realized defaults vary with the cycle. High defaults in a recession with little migration is therefore consistent with TTC design. It does not by itself show loss of differentiation.

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