hard · FRM Part 2 Credit Risk
A stress test scenario provides a 'Recession Transition Matrix' where migrations to lower grades are 50% higher than the baseline.
If a bank uses this matrix in a Markovian M^9 (9-quarter) simulation, what is the most significant structural risk in the resulting capital projection?
- It fails to capture the 'Cliff Effect,' where firms migrate directly from Stage 2 to Stage 3 default status under the IFRS 9 impairment framework.
- The matrix will become mathematically unstable because its rows may no longer sum exactly to 1.0 once the 50% stress increase is applied.
- It violates the Basel Committee's 'Through-the-Cycle' (TTC) mandate that internal ratings must remain stable across economic cycles.
- It assumes the recession-level deterioration persists for the entire 9-quarter period, likely leading to a massive overestimation of capital needs.
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