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

A bank is designing a rating system for its corporate portfolio under the Basel internal ratings-based approach. A risk officer proposes that all obligors be placed into only two grades, 'acceptable' and 'watch', to simplify reporting. Which Basel requirement does this proposal most directly breach?

The proposal breaches the Basel requirement for meaningful risk differentiation, which means exposures must be spread across an adequate number of grades without heavy concentration in one grade. A two-bucket scale cannot separate obligors by default risk, so it fails the IRB rating system design standards.

  1. AThe requirement for a meaningful distribution of exposures across grades, avoiding excessive concentration in any single gradeCorrect
  2. BThe requirement that ratings be assigned only by external agencies
  3. CThe requirement that PDs be estimated using a point-in-time approach only
  4. DThe requirement that LGD be set equal to a supervisory constant for all exposures

Explanation

Basel IRB standards require a rating system to provide a meaningful differentiation of risk, with exposures spread across grades and no excessive concentration. A two-grade scale cannot differentiate risk adequately. The other options misstate Basel requirements, as internal ratings are central to IRB and the PD horizon is not restricted to point-in-time.

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