FRM Exam Part II · Contingency Funding Planning

Liquidity Stress Testing and Scenario Analysis for the CFP

Updated 11 October 2026 · Fact-checked

A liquidity stress test projects cash inflows and outflows under severe but plausible scenarios (idiosyncratic, market-wide or combined) over set time horizons. The survival horizon is the number of days the bank's liquid resources cover cumulative net outflows. Results size buffers and trigger actions in the Contingency Funding Plan (CFP).

Understand Stress Testing and Scenario Analysis for Liquidity

A liquidity stress test asks one question: if funding conditions turn bad, how long can the bank pay its obligations without outside help? Capital losses are not the focus. Cash is. A bank can be solvent on paper and still fail because it cannot roll funding or meet withdrawals.

You build a scenario first. An idiosyncratic scenario hits only your institution, for example a rating downgrade, a fraud or a loss event that damages confidence. A systemic (market-wide) scenario hits everyone, for example a funding market freeze or a sharp fall in asset prices. A combined scenario does both at once. Combined scenarios are usually the most severe because the bank cannot count on other institutions or markets for support. Supervisors expect firms to run all three.

Next you set severity and duration. Severity covers the size of the shocks: deposit run-off rates, the share of wholesale funding that does not roll over, haircuts on collateral, drawdowns on committed credit lines, and extra collateral calls triggered by a downgrade. Duration covers how long the stress lasts. Typical views are overnight, one week, one month, three months and longer. Early days are usually the most intense, and funding stress that lasts longer is harder to survive. Severity should be severe but plausible. If it is too mild, the test tells you nothing. If it is absurd, management ignores it.

Then you project cash flows day by day, apply behavioural assumptions, and compare cumulative net outflows with the counterbalancing capacity: cash, central bank reserves and unencumbered high-quality liquid assets, valued after stressed haircuts. The survival horizon is the first day when cumulative stressed outflows exceed that capacity. Management compares it with its risk appetite, for example a minimum of 30 days under the combined scenario.

Results feed the CFP. They set buffer size, limits and early warning indicator triggers, and they decide which actions the CFP lists, such as asset sales, repo, central bank facilities and cutting new lending. Reverse stress testing works backwards: you find the scenario that would break the bank, then judge how plausible it is.

Key formulas to remember

Survival horizon: Survival horizon = the first day t at which Cumulative net stressed outflows(t) > Counterbalancing capacity(t); Capacity must be measured after stressed haircuts and excluding encumbered assets. Capacity may change over time as assets are monetised.
Net stressed cash outflow: Net outflow(t) = Stressed outflows(t) − Stressed inflows(t); Inflows are often capped or haircut in stress, because counterparties may not pay or may not roll.
Stressed value of a liquid asset: Stressed value = Market value × (1 − haircut); Haircuts are larger for lower-quality assets and in market-wide scenarios.
Liquidity surplus or shortfall: Surplus (shortfall) = Counterbalancing capacity − Cumulative net stressed outflows; A negative figure at a given horizon means a funding gap the CFP must cover.
Run-off outflow: Outflow = Balance × run-off rate; Rates differ by funding type and by scenario, with higher rates for uninsured and wholesale funding.

How to solve Stress Testing and Scenario Analysis for Liquidity questions

Use this order for any scenario, calculation or interpretation question on liquidity stress testing.

1Identify the scenario type: idiosyncratic, systemic or combined. This tells you which assumptions get stressed and whether market access is available.
2Note severity inputs: run-off rates, rollover failure, haircuts, drawdowns and collateral calls. Apply each to the correct balance.
3Note the time horizon and any phasing, for example heavier outflows in the first week.
4Compute stressed outflows and stressed inflows for each period, then cumulative net outflow.
5Value the counterbalancing capacity after haircuts, excluding encumbered or non-transferable assets.
6Compare cumulative net outflow with capacity period by period to find the survival horizon or the shortfall.
7Interpret against the stated risk appetite or minimum horizon, then name the CFP use: buffer resizing, action triggers or limits.

Quickest way: Table-and-compare shortcut

When to use it: Use when a question gives balances, run-off rates and a buffer, and asks for the survival horizon or shortfall.

Multiply each balance by its stated rate and add up the outflows.
Subtract any inflows the question says you can count.
Apply the haircut to each asset and add up the buffer.
Divide the buffer by the daily net outflow if outflows are even. Otherwise accumulate period by period.
Eliminate options that ignore haircuts or use the wrong scenario assumptions.

Common mistakes in Stress Testing and Scenario Analysis for Liquidity

Valuing the buffer at market value instead of after stressed haircuts.
Students focus on the outflows and forget that selling or pledging assets in stress costs value.
Fix: Always apply the haircut first. Buffer = Market value × (1 − haircut).
Treating idiosyncratic and systemic scenarios as the same thing.
Both involve outflows, so the labels blur.
Fix: Idiosyncratic is firm-specific and markets still work. Systemic is market-wide and asset markets and funding are impaired. Combined is both and is usually the most severe.
Counting all assets as available buffer.
Students ignore encumbrance and operational constraints.
Fix: Count only unencumbered assets that can be monetised or pledged in the right currency and entity.
Reading survival horizon as the length of the stress.
Both are measured in days.
Fix: The stress duration is an assumption. The survival horizon is the result: how long resources cover outflows.
Assuming one severity level is enough, or that more extreme is always better.
Students think a harsher test is always more prudent.
Fix: Use several scenarios and durations. Each must be severe but plausible, or it will not drive decisions.
Stopping at the number and not linking it to the CFP.
Students treat the test as a calculation only.
Fix: State how results set buffers and limits, calibrate early warning triggers and shape CFP actions.

Worked examples

Example 1

A bank has USD 800 million of unsecured wholesale funding maturing within 30 days and USD 2,000 million of retail deposits. In a combined scenario, 70% of the wholesale funding fails to roll and 5% of retail deposits run off over 30 days. No inflows are counted. Its liquid assets are USD 300 million cash and USD 500 million government bonds with a 10% stressed haircut. Does the bank survive 30 days, and what is the surplus or shortfall?

Show the solution

Wholesale outflow = 800 × 0.70 = USD 560 million.
Retail outflow = 2,000 × 0.05 = USD 100 million.
Cumulative net outflow = 560 + 100 = USD 660 million.
Bond value after haircut = 500 × (1 − 0.10) = USD 450 million.
Counterbalancing capacity = 300 + 450 = USD 750 million.
Surplus = 750 − 660 = USD 90 million.

Answer: The bank survives 30 days with a surplus of USD 90 million.

Example 2

A bank's stressed net outflow is a flat USD 40 million per day. Its unencumbered liquid assets are USD 600 million of Level 1 bonds with a 5% haircut and USD 400 million of corporate bonds with a 25% haircut. Its policy requires a survival horizon of at least 20 days. Does it comply?

Show the solution

Level 1 after haircut = 600 × 0.95 = USD 570 million.
Corporate bonds after haircut = 400 × 0.75 = USD 300 million.
Capacity = 570 + 300 = USD 870 million.
Survival horizon = 870 ÷ 40 = 21.75 days.
Cumulative outflow exceeds capacity during day 22, so the bank survives 21 full days.
21 days is at least the 20-day requirement.

Answer: The survival horizon is about 21 days (21.75 days before rounding), so the bank complies with the 20-day minimum, with a thin margin.

Exam tips

Read the scenario label first. It tells you which assumptions apply and often eliminates two options.
Check whether the question gives haircuts and whether they apply to buffer assets before you add them.
If an option says the result is the length of the stress, or ignores the CFP, it is usually wrong.
Expect conceptual questions on severe but plausible, reverse stress testing, and why combined scenarios matter.
Do the arithmetic in one pass: outflows, inflows, buffer after haircut, then compare.

Practice questions from Contingency Funding Planning

Stress Testing and Scenario Analysis for Liquidity in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Stress Testing and Scenario Analysis for Liquidity: frequently asked questions

What is the difference between idiosyncratic and systemic liquidity scenarios?

An idiosyncratic scenario affects only your institution, such as a downgrade or reputational event, while markets keep working. A systemic scenario affects the whole market, for example a funding freeze or collateral price drop. A combined scenario applies both and is usually the harshest.

What is the survival horizon in a liquidity stress test?

It is the number of days the bank can meet its stressed net cash outflows using its counterbalancing capacity, without outside support. It is the point where cumulative outflows exceed available liquid resources. Management compares it with a minimum set in its risk appetite.

How do stress test results feed the contingency funding plan?

They size the liquidity buffer, set limits, and calibrate early warning indicator triggers. They also show which CFP actions are needed and how fast, such as asset sales, repo or central bank borrowing.

What is reverse stress testing for liquidity?

You start from the outcome that breaks the bank, such as running out of liquid assets in a set number of days. Then you work back to find the scenario that causes it. You judge how plausible it is and what weaknesses it exposes.