FRM Exam Part II · Liquidity and Reserves Management: Strategies and Policies

Liquidity Buffers and Stress-Based Sizing for FRM Part II

Q: What is the survival horizon?

It is the number of days a bank can meet all obligations under a stress scenario using its buffer and other counterbalancing capacity, without new market funding. It is found by checking when cumulative net outflow first exceeds available liquidity.

Q: How do I size a liquidity buffer using stress scenarios?

Project stressed outflows and inflows over the horizon for each scenario, add contingency needs, and take the worst peak cumulative net outflow. Hold unencumbered liquid assets, after haircuts, at least equal to that amount.

Q: What is the difference between a liquidity buffer and a reserve requirement?

A reserve requirement is a central bank rule that sets a minimum share of deposits to be held as reserves, mainly a monetary policy tool. A liquidity buffer is sized to stressed cash needs and is intended to be drawn down when funding is lost.

Q: Why are haircuts applied to buffer assets?

In stress, assets sell at lower prices or raise less cash in repo. Haircuts reflect this, so the buffer is measured at the cash it would actually produce.

Updated 11 October 2026 · Fact-checked

A liquidity buffer is a stock of unencumbered, high-quality liquid assets held to cover stressed cash outflows. To size it, project cumulative net outflows under each stress scenario over the survival horizon, add contingency needs, then hold liquid assets, after haircuts, at least equal to the worst case.

Understand Liquidity Buffers and Stress-Based Sizing

A liquidity buffer is a pool of assets you can turn into cash quickly, at a predictable price, when funding dries up. Typical examples are central bank reserves, government bonds and other high-quality liquid assets (HQLA). The assets must be unencumbered. If they are already pledged, you cannot use them again.

The buffer is not sized by looking at normal days. You size it from stress scenarios. A scenario might combine a rating downgrade, retail deposit runs, wholesale funding that does not roll over, drawdowns on credit lines and higher collateral calls on derivatives. For each scenario you project cash inflows and outflows day by day.

The survival horizon is how long the bank can meet all its obligations under a scenario using only its buffer and other counterbalancing capacity, without relying on new market funding. A bank sets a minimum horizon, for example 30 days for a severe combined stress, and may set longer horizons for milder scenarios. The buffer must be big enough that the cumulative net outflow never exceeds available liquidity within that horizon.

Two adjustments matter. First, assets are counted at stressed value: apply haircuts to reflect price falls and repo margin. Second, add contingency needs, such as extra collateral from a downgrade, or cash to support a subsidiary or a franchise-critical activity. Inflows are usually capped or discounted, since counterparties may not pay in stress.

Do not confuse a liquidity buffer with a reserve requirement. A reserve requirement is a rule set by the central bank: banks must hold a fixed share of certain deposits as reserves, and that is a policy tool. A liquidity buffer is a risk-based internal (and Basel LCR) holding, sized to stressed outflows, and it is meant to be used in stress.

Key formulas to remember

Cumulative net stressed outflow: Net outflow(t) = Σ stressed outflows(1..t) − Σ stressed inflows(1..t); Calculate for each day up to the survival horizon. The peak value drives buffer size.
Required buffer: Required buffer = max over scenarios of (peak cumulative net outflow + contingency needs); Size to the most severe scenario, not the average.
Stressed value of buffer: Stressed value = Market value × (1 − haircut); Use for each asset. Only unencumbered assets count.
Survival horizon test: Survives to day T if buffer stressed value + other counterbalancing capacity ≥ cumulative net outflow(t) for every t ≤ T; The horizon is the last day this holds. It is a path test, not a single-day test.
Liquidity Coverage Ratio (Basel III): LCR = Stock of HQLA ÷ Total net cash outflows over next 30 calendar days ≥ 100%; Net outflows = outflows − min(inflows, 75% of outflows).

How to solve Liquidity Buffers and Stress-Based Sizing questions

Use this order for any buffer sizing or survival horizon question.

1Identify the scenario and its horizon (for example 30 days, combined idiosyncratic and market-wide).
2List outflows and apply the stated run-off or non-rollover rates to each balance.
3List inflows and apply the stated inflow rates. Check for any cap on inflows.
4Add contingency needs such as collateral calls or committed line drawdowns, if given.
5Compute net outflow, and if a daily path is given, the cumulative net outflow each day.
6Apply haircuts to the buffer assets and exclude encumbered assets.
7Compare stressed buffer with the cumulative need to get the surplus, shortfall, ratio or survival day.
8State the interpretation: size to the worst scenario, and say what management action follows.

Quickest way: Net outflow versus haircut buffer

When to use it: Use when the question gives balances, run-off rates and asset haircuts and asks for the required buffer, surplus or ratio.

Multiply each liability by its run-off rate and add them up.
Multiply each inflow by its inflow rate and subtract.
Add any contingency amount.
Multiply each asset by (1 − haircut) and add them up.
Divide or subtract. Check units and that you used the correct horizon.

Common mistakes in Liquidity Buffers and Stress-Based Sizing

Sizing the buffer to the average or expected scenario.
Students treat it like expected loss.
Fix: Size to the most severe plausible scenario. The buffer must cover the peak cumulative need.
Counting encumbered assets or using market value without haircuts.
Balance sheet amounts look like available cash.
Fix: Exclude pledged assets and apply haircuts. Only the stressed, unencumbered value counts.
Testing only the final day of the horizon.
Students compute total outflow and forget timing.
Fix: Check every day. A bank can be short on day 12 even if it looks fine at day 30.
Assuming full inflows in stress.
Contractual inflows seem certain.
Fix: Apply inflow haircuts and the cap. Under the LCR, inflows count up to 75% of outflows.
Equating a liquidity buffer with a reserve requirement.
Both involve holding liquid assets.
Fix: A reserve requirement is a central bank rule on deposits. A buffer is risk-based and is meant to be drawn on in stress.
Ignoring contingency needs such as collateral calls after a downgrade.
Only deposits and funding are modeled.
Fix: Add off-balance-sheet drawdowns and rating-triggered collateral to the outflows.

Worked examples

Example 1

A bank has retail deposits of USD 400 million with a 10% 30-day run-off, wholesale funding maturing within 30 days of USD 200 million with a 100% non-rollover, and committed credit lines of USD 100 million with a 20% drawdown. Contractual inflows are USD 60 million, assumed fully received. Its HQLA are USD 250 million at stressed value. Find the 30-day net outflow and the LCR-style ratio.

Show the solution

Retail outflow = 400 × 10% = USD 40 million.
Wholesale outflow = 200 × 100% = USD 200 million.
Line drawdown = 100 × 20% = USD 20 million.
Total outflows = 40 + 200 + 20 = USD 260 million.
Inflow cap = 75% × 260 = USD 195 million. The 60 million is below the cap, so it counts in full.
Net outflow = 260 − 60 = USD 200 million.
Ratio = 250 ÷ 200 = 125%.

Answer: Net 30-day outflow is USD 200 million and the ratio is 125%, so the buffer covers the stress with a USD 50 million surplus.

Example 2

A treasury holds USD 80 million of government bonds (haircut 5%) and USD 40 million of corporate bonds (haircut 20%), all unencumbered. A severe scenario gives a cumulative net outflow of USD 95 million by day 14 and USD 120 million by day 30. Contingency needs from a downgrade add USD 10 million. Does the bank survive 30 days? If not, what is the shortfall?

Show the solution

Stressed government bonds = 80 × (1 − 0.05) = USD 76 million.
Stressed corporate bonds = 40 × (1 − 0.20) = USD 32 million.
Stressed buffer = 76 + 32 = USD 108 million.
Need at day 14 = 95 + 10 = USD 105 million. 108 ≥ 105, so the bank survives to day 14.
Need at day 30 = 120 + 10 = USD 130 million. 108 < 130, so it fails by day 30.
Shortfall at day 30 = 130 − 108 = USD 22 million.

Answer: The bank survives to day 14 but not 30 days. Shortfall at day 30 is USD 22 million, so it needs more buffer, or other counterbalancing capacity, or a shorter-horizon plan.

Exam tips

Read the horizon and whether the question asks for a surplus, ratio or shortfall before calculating.
Check whether the asset values given are market values (apply haircut) or already stressed values.
When a daily path is given, find the first day where cumulative need exceeds the buffer. That day is the survival horizon.
For conceptual options, a buffer is sized from stress and can be used. A reserve requirement is a fixed regulatory rule.
Watch for the 75% inflow cap when the question names the LCR.

Practice questions from Liquidity and Reserves Management: Strategies and Policies

Liquidity Buffers and Stress-Based Sizing: frequently asked questions

What is the survival horizon?

It is the number of days a bank can meet all obligations under a stress scenario using its buffer and other counterbalancing capacity, without new market funding. It is found by checking when cumulative net outflow first exceeds available liquidity.

How do I size a liquidity buffer using stress scenarios?

Project stressed outflows and inflows over the horizon for each scenario, add contingency needs, and take the worst peak cumulative net outflow. Hold unencumbered liquid assets, after haircuts, at least equal to that amount.

What is the difference between a liquidity buffer and a reserve requirement?

A reserve requirement is a central bank rule that sets a minimum share of deposits to be held as reserves, mainly a monetary policy tool. A liquidity buffer is sized to stressed cash needs and is intended to be drawn down when funding is lost.

Why are haircuts applied to buffer assets?

In stress, assets sell at lower prices or raise less cash in repo. Haircuts reflect this, so the buffer is measured at the cash it would actually produce.