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FRM Exam Part II · Liquidity Risk Reporting and Stress Testing

Liquidity Stress Testing Design and Scenarios

Updated 11 October 2026 · Fact-checked

A liquidity stress test projects cash inflows, outflows and available buffers under severe but plausible scenarios: institution-specific, market-wide or combined. You set the horizon, assume run-off rates and asset haircuts, then compare stressed outflows with liquid resources. The result is a survival horizon or a surplus or shortfall.

Understand Liquidity Stress Testing Design and Scenarios

Liquidity risk is the risk that a firm cannot meet its payments when due without unacceptable cost. A stress test asks: if conditions turn bad, how long can we pay? It focuses on cash, not on accounting profit or capital.

Scenarios come in three types. An idiosyncratic (institution-specific) scenario hits only your firm, for example a rating downgrade, a fraud loss or a rumour. Depositors and wholesale lenders pull funds, but markets still work, so you can sell assets at near-normal prices. A market-wide (systemic) scenario hits everyone, for example a funding market freeze or a sharp rise in repo haircuts. Asset prices fall and buyers vanish, and everyone competes for the same liquidity. A combined scenario joins both. It is the most severe because your own outflows rise while your buffers are worth less. Regulatory tests such as the LCR assume a combined shock.

Two more design choices matter. The horizon is how long the stress lasts. Short horizons (overnight to one week) capture the first run, when outflows are fastest. Longer horizons (one to three months, and up to a year) capture slower drains, such as loss of term funding. Use several horizons, because a firm can pass at 30 days and fail at 90.

Then you set assumptions. Outflow (run-off) rates state what share of each liability leaves: insured retail deposits run off least, uninsured wholesale and financial-institution deposits run off most, and maturing secured funding depends on collateral quality. You also assume drawdowns on committed credit and liquidity lines, extra collateral calls from a downgrade, and reduced inflows because borrowers roll over. Haircuts cut the value of assets you sell or pledge. Government bonds get small haircuts, and lower-quality or complex assets get large ones. Assumptions should be conservative, documented and linked to history or to regulation.

A scenario stress test starts from a defined event and measures the effect. A reverse stress test starts from the outcome (the firm fails or breaches its limit) and works backwards to find which events would cause it. Reverse tests reveal hidden vulnerabilities that you did not think to model.

Key formulas to remember

Stressed net cash outflow
Net outflow = Σ (balance × run-off rate) + drawdowns + collateral calls − Σ (inflows × inflow rate)
Compute per horizon. Inflows are often capped or haircut because borrowers may not repay on time.
Liquidity buffer after haircuts
Buffer = Σ (market value × (1 − haircut))
Use stressed haircuts, not normal ones. Exclude encumbered assets.
Surplus or shortfall
Surplus = Buffer − Net outflow
Negative means a shortfall. The firm needs more buffer or must cut outflows.
Survival horizon
Survival horizon = the longest horizon at which cumulative buffer ≥ cumulative net outflow
The first day cumulative net outflow exceeds the buffer marks the end of survival.
Scenario hierarchy
Idiosyncratic and market-wide are separate; combined is the most severe
Run all three, plus a reverse stress test.

How to solve Liquidity Stress Testing Design and Scenarios questions

Use this order for any question on designing or reading a liquidity stress test.

  1. 1Identify the scenario type: institution-specific, market-wide or combined. Check what the question says is hit, and whether markets still function.
  2. 2Note the horizon (overnight, 30 days, 90 days) and whether the question wants a short-run or long-run view.
  3. 3List the liabilities and off-balance-sheet items, and match each to a run-off or drawdown rate. Uninsured wholesale funding runs off faster than insured retail.
  4. 4Apply stressed haircuts to the assets in the buffer. Remove assets that are encumbered or cannot be monetised in time.
  5. 5Compute stressed net outflow, then buffer, then surplus or shortfall, and survival horizon if asked.
  6. 6Interpret the result: is the shortfall driven by funding, by asset values, or by both? Say what action follows, such as raising the buffer or lengthening funding.
  7. 7If the question mentions starting from failure, it is a reverse stress test. Work backwards from the breach to the events.

Quickest way: Three-line check: Type, Flows, Buffer

When to use it: Use when a multiple-choice question gives a short scenario and asks which test is used, which assumption is most appropriate, or whether the firm passes.

  1. Type: is only the firm hit (idiosyncratic) or the market too (combined)? Market-wide only means asset sales are impaired.
  2. Flows: multiply each balance by its run-off rate and add drawdowns. Be careful to use outflows minus capped inflows.
  3. Buffer: apply haircuts, then compare. Eliminate options that use normal haircuts or ignore off-balance-sheet drawdowns.

Common mistakes in Liquidity Stress Testing Design and Scenarios

  • Treating an idiosyncratic scenario as if asset markets also freeze.

    Students blend the scenario types into one general crisis.

    Fix: In an idiosyncratic case, haircuts stay near normal and market access remains for others. Add market stress only in market-wide or combined scenarios.

  • Using the same run-off rate for all deposits.

    It is simpler than segmenting the funding base.

    Fix: Segment by insured or uninsured, retail or wholesale, operational or non-operational, and set higher run-off for the flighty segments.

  • Applying haircuts to outflows instead of to assets.

    Haircut and run-off are both percentages, so they get confused.

    Fix: Haircuts reduce the value of buffer assets. Run-off rates scale liability outflows.

  • Confusing a reverse stress test with a severe scenario test.

    Both sound extreme.

    Fix: A scenario test starts with an event and finds the impact. A reverse test starts with the failure outcome and finds the events that produce it.

  • Forgetting off-balance-sheet drawdowns and collateral calls.

    Attention stays on deposits and maturing debt.

    Fix: Add committed lines, derivative margin and downgrade-triggered collateral to stressed outflows.

  • Testing only one horizon.

    Regulatory ratios use a single 30-day window.

    Fix: Run several horizons. Short ones show the run, long ones show structural funding gaps.

Worked examples

Example 1

A bank has the following balances: insured retail deposits $400 million (run-off 5%), uninsured corporate deposits $300 million (run-off 40%), and undrawn committed credit lines of $100 million (drawdown 10%). Inflows are assumed to be $20 million. Its buffer is $90 million of government bonds (haircut 5%) and $60 million of corporate bonds (haircut 25%). Find the 30-day surplus or shortfall.

Show the solution
  1. Retail outflow: 400 × 5% = $20 million.
  2. Corporate outflow: 300 × 40% = $120 million.
  3. Credit line drawdown: 100 × 10% = $10 million.
  4. Total outflows = 20 + 120 + 10 = $150 million. Net outflow = 150 − 20 = $130 million.
  5. Government bonds after haircut: 90 × 0.95 = $85.5 million.
  6. Corporate bonds after haircut: 60 × 0.75 = $45 million.
  7. Buffer = 85.5 + 45 = $130.5 million.
  8. Surplus = 130.5 − 130 = $0.5 million.

Answer: Surplus of $0.5 million. The bank just passes, so any rise in run-off or haircuts would create a shortfall.

Example 2

A risk committee runs a test in which a bank's rating is cut two notches while repo markets and bond prices stay normal. Name the scenario, state what assumptions on haircuts and outflows are appropriate, and explain how a reverse stress test would differ.

Show the solution
  1. Only the bank is affected and markets function, so this is an idiosyncratic (institution-specific) scenario.
  2. Outflows: raise run-off on uninsured wholesale funding and add downgrade-triggered collateral calls and drawdowns.
  3. Haircuts: keep them close to normal because market prices and liquidity are unchanged, though some secured lenders may still demand higher haircuts on this bank's collateral.
  4. A reverse stress test would not start with the downgrade. It would start from a defined failure, for example the buffer being exhausted in 30 days, and ask which combination of events could cause that.
  5. The reverse test may then reveal paths the committee did not consider, such as concentration in one funding provider.

Answer: This is an idiosyncratic scenario with high wholesale run-off and collateral calls but near-normal haircuts. A reverse stress test works backwards from the failure outcome to identify the causes.

Exam tips

  • Read the scenario for what is hit. If markets are impaired, expect higher haircuts. If only the firm is hit, expect higher run-off and collateral calls.
  • The combined scenario is the most severe and is the one regulatory ratios most resemble. Pick it when both funding and asset values are stressed.
  • Always use haircuts on buffer assets and run-off rates on liabilities. Options that swap them are wrong.
  • If an option says reverse stress testing starts from an event, reject it. It starts from the failure outcome.
  • When a result is close, look for items the question may have omitted, such as drawdowns, and check the answer after including them.

Practice questions from Liquidity Risk Reporting and Stress Testing

Liquidity Stress Testing Design and Scenarios in other exams

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

Liquidity Stress Testing Design and Scenarios: frequently asked questions

What is the difference between idiosyncratic and market-wide liquidity stress?

An idiosyncratic stress affects one institution, for example through a downgrade or loss of confidence, while markets keep working. A market-wide stress affects many firms at once and hurts asset prices and market access. A combined scenario applies both and is the harshest.

What is the difference between a reverse stress test and a scenario stress test for liquidity?

A scenario test starts from a defined event and measures its effect on cash and buffers. A reverse stress test starts from a failure outcome, such as running out of liquidity, and identifies the events that could cause it. It helps find vulnerabilities not captured by chosen scenarios.

How are deposit run-off rates chosen?

They are set by segment, with insured retail deposits assumed to leave least and uninsured wholesale deposits most. Firms base them on past behaviour, crisis experience and regulatory benchmarks, and keep them conservative. They should be documented and reviewed.

Why use more than one stress horizon?

Different risks appear over different time spans. A short horizon captures the initial run, while longer ones capture loss of term funding and slow outflows. A firm can survive 30 days yet fail over 90.