FRM Exam Part II · Liquidity Risk

Liquidity Stress Testing and Contingency Funding Plans

Updated 11 October 2026 · Fact-checked

Liquidity stress testing projects an institution's cash inflows and outflows under adverse scenarios and compares the net outflow with its liquidity buffer to find the survival horizon. A contingency funding plan sets out triggers, funding sources, roles and actions to use if stress hits. Solve questions by tracing outflows, haircuts and buffer.

Understand Liquidity Stress Testing and Contingency Funding Plans

Liquidity risk is the risk that a firm cannot meet its payment obligations as they fall due, at acceptable cost. A bank can be solvent and still fail because cash runs out. Liquidity stress testing asks one question: if conditions turn bad, how long can we pay everyone?

The starting point is the cash flow projection. You list contractual inflows and outflows by time bucket (overnight, 1 week, 1 month, 3 months and so on). The difference in each bucket is the liquidity gap, and the running total is the cumulative gap. Contractual flows are then adjusted with behavioural assumptions: how many deposits will actually leave, how many credit lines will be drawn, how many loans will be rolled over.

Next come stress scenarios. These cover an institution-specific shock (for example a rating downgrade), a market-wide shock (for example frozen wholesale markets), and a combined shock. Stress applies run-off rates to funding, draw-down rates to commitments, extra collateral calls, and haircuts to assets. A reverse stress test works backwards: it finds the scenario that would exhaust the buffer.

The liquidity buffer (also called counterbalancing capacity) is the stock of unencumbered, high-quality liquid assets and other reliable sources the firm can turn into cash. Under stress you value it after haircuts and only count assets that are truly unencumbered and operationally available. Dividing the buffer by the stressed net outflow per day gives the survival horizon.

A contingency funding plan (CFP) turns the results into action. It lists early warning indicators (EWIs) such as widening CDS spreads, falling deposit balances, rising reliance on short-term funding, and falling share price. It defines escalation triggers, a crisis team, funding sources in order of use, communication to markets and regulators, and regular testing. The CFP must be consistent with the stress test and reviewed often.

Key formulas to remember

Net cash flow in a bucket: Net cash flow = Inflows − Outflows; A negative value is a liquidity gap (shortfall) in that bucket.
Cumulative gap: Cumulative gap(t) = Σ net cash flow from bucket 1 to t; Compare it with the buffer at each horizon, not only at one date.
Stressed outflow: Stressed outflow = Balance × run-off rate; Apply run-off to deposits and wholesale funding; apply draw-down rate to undrawn commitments.
Buffer value after haircut: Buffer value = Market value × (1 − haircut); Only count unencumbered assets. Haircuts are larger for riskier or less liquid assets.
Survival horizon: Survival horizon = Buffer ÷ stressed net outflow per period; Valid when daily outflow is roughly constant; otherwise deplete the buffer bucket by bucket.
Liquidity surplus or shortfall: Surplus (shortfall) = Buffer − cumulative stressed net outflow; A negative result means the CFP must supply extra funding.

How to solve Liquidity Stress Testing and Contingency Funding Plans questions

Use this order for any question on liquidity stress tests, buffers or CFPs.

1Identify the scenario: institution-specific, market-wide or combined, and the time horizon.
2List the stressed outflows: apply run-off rates to deposits and wholesale funding, draw-down rates to commitments, and add collateral calls.
3List the inflows that still hold under stress. Assume loans are not rolled over unless told otherwise, and apply inflow caps if stated.
4Compute net outflow by bucket and the cumulative gap.
5Value the buffer: apply haircuts, exclude encumbered assets, and use the correct currency and access.
6Compare buffer with cumulative outflow to get the surplus, shortfall or survival horizon.
7Link to the CFP: name the triggers, the actions and the contingent sources if there is a shortfall.
8Check that the answer fits the wording (days, amount or qualitative action) and the units.

Quickest way: Buffer minus stressed outflow in three lines

When to use it: Numerical MCQs that give balances, run-off rates and a buffer.

Multiply each balance by its stress rate and add the results to get total stressed outflow.
Subtract stressed inflows, then compute the buffer after haircuts.
Subtract or divide as asked: surplus = buffer − net outflow; horizon = buffer ÷ daily net outflow.
For qualitative options, pick the answer that is forward-looking, board-owned and tied to tested triggers.

Common mistakes in Liquidity Stress Testing and Contingency Funding Plans

Using the market value of buffer assets without haircuts.
The buffer looks like cash on the balance sheet.
Fix: Apply the haircut first: value × (1 − haircut). Then compare with outflows.
Counting encumbered assets as part of the buffer.
Students focus on asset quality, not availability.
Fix: Include only unencumbered assets that can be sold or repoed promptly.
Applying run-off to the wrong item, or applying 100% to all funding.
Stress rates differ by funding type and are mixed up.
Fix: Use the rates given: run-off for deposits and wholesale funding, draw-down for undrawn lines. Do not invent rates.
Treating the stress test as only a regulatory ratio such as LCR.
LCR is a fixed 30-day standard and is easy to memorise.
Fix: Remember that internal stress tests use own scenarios, several horizons and behavioural assumptions, and may be tougher than regulatory ones.
Thinking a CFP is only a list of funding sources.
The word 'funding' dominates the title.
Fix: A CFP also covers EWIs, triggers, governance, communication and testing.
Looking only at the final cumulative gap.
It is a single number and seems enough.
Fix: Check each bucket. The buffer can run out in week one even if the 3-month gap looks fine.

Worked examples

Example 1

A bank has retail deposits of USD 2,000 million and wholesale funding of USD 800 million maturing within 30 days. Undrawn committed lines are USD 500 million. Stress assumptions: 10% run-off of retail deposits, 100% run-off of wholesale funding, 20% draw-down of lines. Stressed inflows are USD 150 million. The buffer is USD 600 million of government bonds with a 5% haircut and USD 100 million of cash. What is the 30-day surplus or shortfall?

Show the solution

Retail outflow = 2,000 × 10% = USD 200 million.
Wholesale outflow = 800 × 100% = USD 800 million.
Line draw-down = 500 × 20% = USD 100 million.
Total stressed outflow = 200 + 800 + 100 = USD 1,100 million.
Net outflow = 1,100 − 150 = USD 950 million.
Bond value after haircut = 600 × (1 − 0.05) = USD 570 million.
Buffer = 570 + 100 = USD 670 million.
Surplus (shortfall) = 670 − 950 = −USD 280 million.

Answer: A shortfall of USD 280 million; the CFP would need to supply this.

Example 2

A firm has a stressed net outflow of EUR 40 million per day and a buffer of EUR 300 million before haircuts, made up of EUR 200 million of covered bonds with a 10% haircut and EUR 100 million of cash. Approximately how many days can it survive, assuming constant outflow?

Show the solution

Covered bonds after haircut = 200 × (1 − 0.10) = EUR 180 million.
Buffer = 180 + 100 = EUR 280 million.
Survival horizon = 280 ÷ 40 = 7 days.

Answer: 7 days. The firm's CFP triggers should fire well before day 7.

Exam tips

For numbers, write outflow, inflow, buffer and result as separate lines. Most errors are skipped haircuts.
Watch for words such as unencumbered, committed versus uncommitted, and institution-specific versus market-wide. They change the answer.
In CFP questions, prefer options that mention tested triggers, clear governance and diversified contingent sources over one-off fixes.
Early warning indicators are forward-looking signals, not losses already incurred. Separate them from triggers, which prompt defined actions.
Remember a reverse stress test starts from failure and finds the scenario, rather than starting from a scenario.

Practice questions from Liquidity Risk

Liquidity Stress Testing and Contingency Funding Plans in other exams

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

CMA FinalStress Testing and Contingency Funding Plan

Liquidity Stress Testing and Contingency Funding Plans: frequently asked questions

What is a contingency funding plan in FRM Part II?

It is a documented plan for managing a liquidity crisis. It sets early warning indicators, escalation triggers, a crisis team, contingent funding sources and communication steps. It should be linked to stress test results and tested regularly.

How is liquidity stress testing different from VaR?

VaR measures potential market value loss over a horizon at a confidence level. Liquidity stress testing measures whether cash and buffers cover stressed outflows over time. It uses scenarios and behavioural assumptions, not a statistical quantile.

What goes into a liquidity buffer?

The buffer holds unencumbered, high-quality liquid assets and other reliable sources of cash, valued after haircuts. Assets that are pledged or hard to sell quickly should not count at full value.

What are examples of early warning indicators?

Examples are deposit outflows, widening CDS or funding spreads, falling credit rating or share price, rising reliance on short-term wholesale funding and more collateral calls. Firms set thresholds so that breaches trigger escalation.