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

When a bank validates its internal rating system, it finds that borrowers rated in the best grades defaulted at a similar rate to borrowers in the middle grades. Which property of the rating system is most clearly deficient?

Discriminatory power is deficient. A good rating system should rank-order borrowers so that better grades have clearly lower default rates. If top and middle grades default at similar rates, the system cannot separate low-risk from higher-risk borrowers, regardless of philosophy or number of grades.

  1. ADiscriminatory power (ability to rank-order borrowers by risk)Correct
  2. BStability of grades over the cycle
  3. CGranularity of the rating scale
  4. DUse of through-the-cycle philosophy

Explanation

If best and middle grades default at similar rates, the system fails to separate good from bad credits, which is poor discriminatory power (low accuracy ratio or AUC). Stability and philosophy describe how ratings move over time, and granularity concerns number of grades, none of which is shown by this finding.

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