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

A bank's internal rating system is point-in-time (PIT). During a sharp economic downturn, what is the most likely effect on its rating migration and on the bank's capital requirements under a rating-based approach, relative to a TTC system?

A point-in-time system downgrades many borrowers in a downturn, raising estimated default probabilities and therefore risk-weighted assets and required capital. This makes capital requirements procyclical, tightening just when capital is scarce, whereas a through-the-cycle system would show fewer rating migrations and smoother capital requirements.

  1. ARatings migrate downward more, so risk-weighted assets and required capital rise more sharply, making capital requirements procyclicalCorrect
  2. BRatings remain unchanged, so capital requirements remain flat throughout the downturn
  3. CRatings migrate upward because default probabilities fall in recessions, reducing capital requirements
  4. DRatings migrate downward but capital requirements fall because the loss given default decreases

Explanation

PIT ratings reflect current conditions, so in a downturn many borrowers are downgraded and estimated PDs rise. Under a rating-based capital approach this raises risk-weighted assets and capital needs just when capital is scarce, which is procyclicality. A TTC system would show less migration. The other options contradict this link.

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