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

An analyst studies an agency's rating history. Grade BB shows a one-year default rate of 1.0% on average, but across 20 years annual BB default rates ranged from 0.0% to 4.0%, with highest values in recessions. The analyst proposes using the 1.0% average as the PD for a BB loan in the bank's IFRS 9-style ECL and economic capital models for the coming year, when a recession is forecast. What is the main flaw?

The flaw is using an unconditional long-run average when defaults are cyclical and correlated with the economy. With a recession forecast, the conditional PD for BB is likely well above 1.0%, so expected loss and tail capital would be understated.

  1. AAverages cannot be computed from agency data
  2. BHistorical default rates are only reported for investment grade
  3. CThe long-run average ignores the cyclical variation and correlation of defaults with the economy, likely understating the conditional PD and the tail loss in a recessionCorrect
  4. DThe average overstates PD because default rates in recessions are always below average

Explanation

Rating-grade average default rates are unconditional; the realized rate is dispersed and clusters in downturns because of common systematic factors. Using 1.0% when a recession is forecast underestimates the conditional PD and understates capital needs in the tail. Option D reverses the relationship.

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