medium · FRM Part 2 Credit Risk
A bank utilizes a through-the-cycle (TTC) rating system for its internal capital adequacy assessment. During a period of significant economic expansion, the risk committee observes that while the actual number of defaults within the 'BB' rating bucket has decreased by 40%, the ratings for the individual obligors in that bucket have remained unchanged.
Which property of transition matrices is most likely being demonstrated, and what is the regulatory implication?
- The absorbing state property; realized defaults are lower because firms cannot migrate out of the default state.
- Point-in-time sensitivity; the bank will face a capital cliff when the cycle turns.
- Stability of ratings in a TTC system; the resulting capital requirements are less procyclical.
- Rating migration momentum; the system is failing to capture the 'significant increase in credit risk' required by accounting standards.
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