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

A bank's internal rating system assigns obligors to grades using current macroeconomic conditions, so that an obligor's PD estimate rises sharply in recessions and falls in expansions. A supervisor reviewing the system for capital purposes is most likely to be concerned that this approach will:

Point-in-time ratings respond quickly to the economic cycle, so PDs and risk-weighted assets rise in downturns and fall in booms. That makes capital requirements procyclical, tightening capital just when banks can least raise it, which is why supervisors worry about this design.

  1. AMake minimum capital requirements procyclical, increasing in downturns when capital is scarceCorrect
  2. BCause PDs to be identical across all grades
  3. CMake the bank's ratings insensitive to obligor-specific information
  4. DUnderstate capital requirements in downturns relative to a through-the-cycle approach

Explanation

Point-in-time ratings migrate with the cycle, so risk-weighted assets and capital requirements rise in recessions and fall in booms, amplifying procyclicality. A through-the-cycle approach is more stable. Option D reverses the effect.

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