I've failed two exams in my time, each in a different style.
My teachers thought I was ready, and I certainly thought I was ready, but since the performances that I gave those days did not meet the standards, I did not pass. Of course I was upset, but life moves on, and the last thing I'm going to do is curl up into a blubbering ball of misery for the rest of my life.
This is the same way I see it with other students, as I strongly agree with Kacey. A student who has no chance of passing an exam will simply not be given an exam form. Whether this is due to lack of preparation, or unfortunate circumstances (injuries, etc), it matters not.
Also, a student who has not trained consistently, with an acceptable level of intensity, will not be allowed to take the exam, even if he knows all of the material. The exams actually begin from the moment after the student has received the belt that he is wearing, and each student is evaluated throughout the quarter.
There are some students who try to get away with as little effort as possible, and then crank it up when test time rolls around. Most of the time, I don't bother giving them exam forms, and will tell them specifically, that they need to keep "cranking it up" on a regular basis, and not just for a week.
Yes, there are some students who might be better served by letting them take the exam at the more advanced ranks, since there's so much material, that they cannot possibly do well just by cramming. This would teach them a lesson about slacking off, but it would also be an insult to those taking the exam, since those folks earned the right to be there by their hard work.
Unfortunately, even good students can have a disruptive moment in their trains of thought. However, if they are good students, then they should use the failure of an exam as a powerful motivational tool, and come out even stronger than before.