FRM Exam Part II · Early Warning Indicators

Types of Early Warning Indicators in Liquidity Risk

Updated 11 October 2026 · Fact-checked

Early warning indicators (EWIs) are signals that a liquidity problem may be building. Internal (bank-specific) indicators come from the bank's own data, such as funding concentration or deposit outflows. External (market-wide) indicators come from markets, such as CDS spreads, rating changes and equity declines. To answer questions, classify the signal, then say what it implies.

Understand Types of Early Warning Indicators

An early warning indicator is a measurable signal that liquidity stress may be approaching. It does not measure the stress itself. Its job is to give management time to act, for example by activating the contingency funding plan (CFP) before a crisis.

Indicators fall into two groups. Internal (bank-specific) indicators come from the bank's own balance sheet, funding and operations. They show problems inside the institution. Examples: rising funding concentration (too much from few providers or one product), deposit outflows above normal, shortening of funding maturities, growing reliance on short-term wholesale funding, increased use of central bank facilities, falling liquid asset buffers, and a widening gap between cash inflows and outflows.

External (market-wide) indicators come from financial markets and third parties. They show how outsiders see the bank or the system. Examples: widening CDS spreads on the bank's debt, credit rating downgrades or negative outlooks, equity price declines, wider bond spreads, higher funding costs in interbank or repo markets, and falling market liquidity. Some are about the bank (its own CDS spread). Others are about the whole market (interbank stress).

The key point for the exam is the source and the speed. Internal indicators are often the first sign, because the bank sees its own deposits and funding daily. External indicators reflect market perception and can move fast, but may be noisy. A rating downgrade, for example, often lags the problem and can then trigger collateral calls and funding loss. A good framework uses both types, with thresholds that escalate from monitoring to action.

Keep the wording careful. An indicator is a warning, not proof of a crisis. A single indicator can be a false alarm. Several indicators moving together is stronger evidence.

Key formulas to remember

Internal (bank-specific) indicators: Source = bank's own data: funding concentration, deposit outflows, maturity shortening, buffer decline, rising reliance on wholesale funding; Observed directly by the bank, usually daily or weekly. Often the earliest signal.
External (market-wide) indicators: Source = markets and third parties: CDS spreads, rating changes, equity price declines, bond spreads, interbank and repo conditions; Reflect market perception. Can move fast but may be noisy or lag.
Funding concentration share: Concentration = funding from largest provider (or product) ÷ total funding; A higher share means higher risk if that source withdraws. No universal threshold; the bank sets its own.
Net deposit outflow rate: Outflow rate = (Deposits at start − Deposits at end) ÷ Deposits at start; Compare with the normal range for the period. Unusual size or speed is the warning.

How to solve Types of Early Warning Indicators questions

Use this method for any question that asks you to identify, classify or interpret an early warning indicator.

1Read the scenario and list each signal mentioned (deposits, spreads, ratings, equity, funding mix).
2Ask where each signal comes from: the bank's own records (internal) or the market and outsiders (external).
3Check whether an external signal is about the bank itself (its own CDS, rating, share price) or about the whole market (interbank rates, sector spreads).
4Compute any simple ratio needed, such as outflow rate or concentration share, and compare it with the threshold given.
5Judge severity: one signal is a watch item; several together, or a breach of a trigger, point to action.
6State the implication in terms of liquidity: funding loss, higher costs, collateral calls, or the need to activate the contingency funding plan.
7Match your answer to the option that is precise, not just plausible.

Quickest way: Source test and speed test

When to use it: Multiple-choice questions asking you to classify an indicator or choose the best example.

Source test: if the data sits in the bank's own systems, it is internal. If it is priced or published by markets or agencies, it is external.
Speed test: internal signals are usually earliest; ratings usually lag.
Eliminate options that describe a result (a funding crisis) rather than a signal.
Eliminate options that overstate, such as one indicator proving a run.
Pick the option that names the right type and a correct implication.

Common mistakes in Types of Early Warning Indicators

Classifying CDS spreads as internal because they refer to the bank.
The spread is about the bank, so it feels bank-specific.
Fix: Classify by data source. CDS spreads are set by the market, so they are external, even if they relate to the bank's own name.
Treating a rating downgrade as an early signal.
Downgrades feel like the first sign of trouble.
Fix: Ratings often lag market and internal signals. A downgrade is still an indicator, and it can trigger further funding loss or collateral calls.
Treating bank-specific and market-wide as the same thing.
Both groups warn of stress, and external signals can be about the bank.
Fix: Bank-specific means unique to that institution. Market-wide affects many institutions. Decide which is being described.
Saying one indicator proves a liquidity crisis.
Students overread a single alarming figure.
Fix: An indicator is a warning. Look for several signals moving together or a breach of a trigger before concluding.
Confusing indicators with liquidity metrics such as LCR.
Both are used in liquidity monitoring.
Fix: EWIs are forward-looking signals with thresholds linked to the contingency funding plan. LCR is a regulatory ratio of buffers to stressed outflows.

Worked examples

Example 1

A bank reports the following over one month: (i) its 5-year CDS spread widens from 90 bp to 210 bp; (ii) insured and uninsured deposits fall faster than normal; (iii) its largest wholesale funding provider now supplies a larger share of funding; (iv) its share price falls. Which of these are internal indicators?

Show the solution

Apply the source test to each signal.
(i) CDS spread is priced by the market: external.
(ii) Deposit outflows are seen in the bank's own records: internal.
(iii) Funding concentration comes from the bank's funding data: internal.
(iv) Share price is set by the equity market: external.

Answer: Items (ii) deposit outflows and (iii) funding concentration are internal. Items (i) CDS spread and (iv) share price decline are external.

Example 2

A bank has deposits of USD 40 billion at the start of a week and USD 38.6 billion at the end. Normal weekly net outflow is below 1%. Its largest wholesale funder supplies USD 6 billion of total funding of USD 60 billion. What does the outflow tell you, and what is the concentration share?

Show the solution

Outflow = 40 − 38.6 = USD 1.4 billion.
Outflow rate = 1.4 ÷ 40 = 0.035, which is 3.5%.
Compare: 3.5% is well above the normal level of under 1%, so this is an unusual outflow.
Concentration share = 6 ÷ 60 = 0.10, which is 10%.
Interpret: the outflow is an internal warning signal. The 10% share alone gives no verdict without the bank's own threshold.

Answer: The weekly outflow rate is 3.5%, far above normal, so it is an internal early warning signal that should be escalated. The largest funder's share is 10%, which needs a comparison with the bank's limit.

Exam tips

Classify by data source, not by who the signal is about. This is the most common test.
Know at least three examples of each type: internal (funding concentration, deposit outflows, buffer decline) and external (CDS spreads, rating changes, equity price declines).
Read for words such as bank-specific and market-wide. They tell you which group the question wants.
When a question asks for the best response, think escalation: monitor, then act, then activate the contingency funding plan.
Beware of options that call a single indicator conclusive.

Practice questions from Early Warning Indicators

Types of Early Warning Indicators: frequently asked questions

What is the difference between internal and external early warning indicators?

Internal indicators come from the bank's own data, such as deposit outflows and funding concentration. External indicators come from markets and agencies, such as CDS spreads, rating changes and equity prices. The difference is the source of the data.

Is a bank's own CDS spread an internal or external indicator?

It is external. The market sets the spread, even though it refers to the bank. It is a market perception signal of the bank's credit risk.

Which indicators usually warn first?

Internal indicators are often first, because the bank sees its deposits and funding daily. Market signals can move fast too. Ratings usually lag. The order can vary by situation.

How are early warning indicators used in a contingency funding plan?

Each indicator has a threshold or trigger. When it is breached, the plan sets the escalation, such as closer monitoring, management review or activating contingent funding sources.