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

A bank's internal rating system for corporate borrowers has 12 non-default grades. Review shows 70% of exposures sit in two adjacent grades. Under Basel IRB requirements on grade structure, what is the most appropriate supervisory concern?

The concern is that the rating system may not provide a meaningful distribution of exposures across grades. Basel IRB requires that no single grade or narrow range hold excessive concentration, because that signals weak risk differentiation. Higher LGDs or external ratings do not cure this weakness.

  1. AThe system is acceptable because concentration shows conservative rating
  2. BThe system may fail the requirement of meaningful distribution of exposures across grades, so no excessive concentration in any gradeCorrect
  3. CThe system must be replaced by external ratings because concentration is prohibited in any grade
  4. DThe system is acceptable provided that the LGD estimates are higher

Explanation

Basel requires a meaningful distribution of exposures across grades without excessive concentration in any single grade or narrow range. 70% in two adjacent grades suggests weak differentiation. Concentration is not prohibited outright, nor cured by higher LGDs, and external ratings are not mandated.

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