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FRM Part II · FRM Exam Part II · Credit Risk

A bank uses a rating system where each grade's PD is calibrated to a long-run average default rate across the economic cycle. During a boom, a firm's financial ratios improve markedly, but its rating stays unchanged while its current default risk falls. Which type of rating system is this, and what is the main consequence?

This is a through-the-cycle system. Ratings reflect long-run creditworthiness and ignore temporary cyclical improvement, so they are stable and dampen procyclicality, but the assigned PD may understate how current risk has fallen in a boom or overstate it in a downturn.

  1. AThrough-the-cycle; ratings are stable but PDs may not reflect current conditionsCorrect
  2. BPoint-in-time; ratings are volatile and track current conditions
  3. CThrough-the-cycle; ratings are highly procyclical
  4. DPoint-in-time; ratings are stable across the cycle

Explanation

Through-the-cycle ratings focus on the firm's long-run, stressed-condition creditworthiness, so they change little with the cycle. This gives stability and lower procyclicality of capital but PDs may differ from current default risk. Point-in-time systems move with current conditions.

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