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Tell apart rating systems that look through the cycle from those that are point-in-time.

FRM® Part II · Credit Risk Measurement and Management · Credit Scoring and Rating · FRM2.CR.6.b

The idea

A through-the-cycle (TTC) rating assesses the borrower over a full economic cycle, typically assuming stressed trough conditions, so the grade moves only when the borrower's lasting credit quality changes. Ratings are stable and migrate little, but the realised default rate of each grade swings with the cycle, higher in recessions. A point-in-time (PIT) rating estimates default probability over the next year given current conditions, using inputs such as market prices and macro data. Borrowers migrate to worse grades in downturns, while the PD attached to each grade stays roughly stable. Agency ratings are mostly TTC. Market-based measures such as equity-implied PDs are PIT. A TTC PD is the long-run average default rate, not the current-year rate. PIT systems make capital and provisions more procyclical, rising in recessions, which is the usual exam point.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which statement describes a through-the-cycle (TTC) rating philosophy?

  1. Ratings reflect current conditions and are revised promptly whenever market prices or macro conditions move materially.Why not: Describes a point-in-time system, not a through-the-cycle one.
  2. Ratings assess credit quality across a full cycle, often at stressed trough conditions, and change mainly for lasting shifts. - correct
  3. Ratings come mainly from equity price volatility and leverage and give a one-year-ahead default probability for the firm.Why not: Describes a market-based structural model, which is typically point-in-time.
  4. Ratings are fixed at origination and are not reviewed until default or maturity.Why not: Confuses stability with being static; TTC ratings are still reviewed and change when credit quality changes lastingly.

TTC ratings look through cyclical swings, so they migrate little over the cycle. PIT ratings reflect current-year conditions and move with the cycle.

A harder one

A bank moves its internal-ratings-based capital calculation from a TTC rating system to a PIT rating system. Other things equal, what is the most likely consequence for regulatory capital over the cycle?

  1. Capital requirements become more volatile and rise in recessions as borrowers migrate to higher-PD grades. - correct
  2. Capital falls in recessions because PD estimates are anchored to long-run average default rates rather than current ones.Why not: Describes the effect of a TTC system; PIT PDs are not anchored to long-run averages.
  3. Capital is unchanged, because only LGD and EAD, not PD, drive the risk-weighted assets of the portfolio.Why not: Ignores that PD is a main input to the IRB risk weight, so changes in PD change capital.
  4. Capital becomes less volatile because PIT removes the cyclical component of PD.Why not: Reverses the effect: PIT keeps the cyclical component and so makes capital more volatile.

With PIT grading, recession pushes borrowers into higher-PD grades, raising risk weights just when capital is scarce. A TTC system dampens this by holding grades and PDs steadier.

The hardest tier

A bank assigns grade 5 borrowers a TTC PD equal to the long-run average one-year default rate of the grade. Over a representative 10-year cycle the grade's default rates were 0.8% in each of 4 expansion years, 1.5% in each of 3 neutral years and 4.1% in each of 3 recession years. Which TTC PD is closest to the correct figure?

  1. 0.8%Why not: Uses the expansion-year default rate rather than averaging across the cycle.
  2. 4.1%Why not: Uses the recession-year default rate, a current-year PIT figure in a downturn, rather than the cycle average.
  3. 2.13%Why not: Takes the simple average of the three state rates (0.8, 1.5, 4.1) without weighting by the years spent in each state.
  4. 2.00% - correct

Weighted average = (4 x 0.8 + 3 x 1.5 + 3 x 4.1) / 10 = (3.2 + 4.5 + 12.3) / 10 = 2.0%. A TTC PD is the long-run average rate, weighted by time spent in each state.

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