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

A bank uses an external-ratings-based approach in which risk weights step up sharply as ratings fall. In a recession, many of its corporate borrowers are downgraded at once. Which consequence best illustrates the criticism that ratings-based frameworks are procyclical?

Procyclicality is shown when downgrades in a recession raise risk weights and required capital, pushing banks to restrict lending just when credit is most needed. This amplifies the downturn. The opposite, lower capital and more lending in a recession, is not what ratings-based frameworks produce.

  1. AHigher required capital forces the bank to cut lending when the economy is weak, deepening the downturnCorrect
  2. BLower required capital encourages the bank to lend more during the downturn
  3. CRating agencies stop publishing ratings for downgraded issuers
  4. DDefault probabilities for investment-grade issuers become constant over time

Explanation

Downgrades raise risk weights and so required capital. A capital-constrained bank tends to reduce credit supply when the economy is weak, amplifying the downturn. Option B has the direction of the effect reversed.

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