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FRM Part I · FRM Exam Part I · External and Internal Credit Ratings

A bank's internal rating system is described as 'through-the-cycle' (TTC). Which of the following best describes the expected behaviour of its ratings and associated probabilities of default (PDs) over a business cycle?

A through-the-cycle system rates borrowers on their long-run, stress-adjusted creditworthiness, so ratings change little over the cycle. Because the grades are stable, the realized default rate within each grade still fluctuates, rising in recessions, unlike a point-in-time system where ratings migrate with conditions.

  1. ARatings are highly sensitive to current economic conditions, so PDs for a given grade rise sharply in recessions
  2. BRatings focus on the obligor's long-run, stressed-scenario creditworthiness, so migrations are relatively stable across the cycle while realized default rates per grade varyCorrect
  3. CRatings are updated daily using equity market prices, so each grade has a constant realized default rate
  4. DRatings are assigned only at loan origination and never reviewed, so no migration occurs

Explanation

A TTC system rates obligors on their expected condition through a full cycle, assuming stress-like conditions, so ratings are stable. As a result, the realized default rate within a grade is procyclical (higher in downturns). Option A describes a point-in-time system.

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