FRM Part II · FRM Exam Part II · Governance
A bank's rating model is validated by the same team that developed it, and the credit officers who approve loans also set the rating override criteria and receive bonuses based on loan volume. Which governance weakness is the most fundamental?
The most fundamental weakness is the lack of independence and the conflicting incentives: developers validate their own model, and volume-bonused credit officers control overrides. This compromises objectivity and encourages rating inflation. Sound governance separates development, validation and use, and aligns incentives with risk-adjusted outcomes.
- ALack of independence and conflicting incentives between model development, validation and the business lines using the ratingsCorrect
- BInsufficient use of external credit ratings in the model
- CAn excessive number of rating grades in the master scale
- DUse of a quantitative model rather than a purely judgmental approach
Explanation
Validation by the developers lacks objectivity, and volume-based bonuses for those who control overrides create an incentive to inflate ratings. Independence and aligned incentives are core governance principles. The other items are design choices, not the root governance failure.
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