FRM Exam Part II · Monitoring Liquidity

Liquidity Stress Testing and Contingency Funding Plans

Updated 11 October 2026 · Fact-checked

Liquidity stress testing projects a bank's cash inflows and outflows under severe but plausible scenarios to see whether its liquid assets last through a chosen horizon. A contingency funding plan (CFP) sets out triggers, actions, funding sources and roles to use when early warning indicators signal stress. Solve questions by matching scenario, assumptions, buffer and response.

Understand Liquidity Stress Testing and Contingency Funding Plans

Liquidity risk is the risk that a bank cannot meet its payments as they fall due without unacceptable cost. A bank can be solvent and still fail because cash runs out. Stress testing and contingency planning exist to catch this early.

A liquidity stress test projects net cash flows over set horizons, such as overnight, 30 days and 90 days, under adverse conditions. You apply run-off rates to liabilities, drawdown rates to commitments, haircuts to assets and limits on rolling over funding. You then compare the cumulative net outflow with the counterbalancing capacity: the liquid assets and other sources the bank can use to raise cash. The time until the buffer is used up is the survival horizon.

Scenarios come in three types. A idiosyncratic scenario hits only the bank, for example a ratings downgrade or a fraud loss. A market-wide scenario hits everyone, for example a funding market freeze. A combined scenario does both and is the most severe. Good scenarios are severe but plausible, cover different horizons, and reflect the bank's own business model. Reverse stress testing starts from a failure outcome, such as the buffer running out, and asks what events would cause it.

Early warning indicators (EWIs) are signals that stress may be building. Examples are rising wholesale funding costs, falling deposits, widening CDS spreads, a falling share price, shorter funding tenors, more collateral calls, and downgrades. Each should have a threshold that triggers escalation.

A contingency funding plan is the playbook for a liquidity crisis. Core components are: governance and a crisis team with clear roles, EWIs and escalation triggers, stress scenarios linked to the plan, a list of contingent funding sources with realistic size and speed, communication plans for regulators, investors, depositors and staff, and regular testing and updates. A CFP must be actionable. Assumed sources such as central bank facilities must be operationally ready, with collateral pre-positioned.

Key formulas to remember

Net cash outflow in stress: Net outflow = Stressed outflows − Stressed inflows; Apply run-off rates to liabilities and haircuts or lower inflow rates to assets. Do this for each horizon.
Stressed outflow on a liability: Outflow = Balance × Run-off rate; Less stable funding, such as unsecured wholesale, has higher run-off than stable retail deposits.
Survival check: Survives if Counterbalancing capacity (after haircuts) ≥ Cumulative net outflow; Use the value of assets after haircuts, not market value.
Survival horizon: Survival horizon = last period before cumulative net outflow exceeds counterbalancing capacity; The first period where cumulative net outflow exceeds capacity is the breach date, not the survival horizon. If the buffer is never exceeded, the bank survives the full horizon.
Liquidity Coverage Ratio: LCR = Stock of HQLA ÷ Total net cash outflows over 30 days ≥ 100%; Regulatory 30-day stress measure. Net outflows have inflows capped at 75% of outflows.

How to solve Liquidity Stress Testing and Contingency Funding Plans questions

Use the same sequence for any question on stress design, indicators or the CFP.

1Identify what is asked: scenario design, a calculation, an indicator, or a CFP component.
2Classify the stress: idiosyncratic, market-wide or combined, and note the horizon.
3List the assumptions given: run-off rates, drawdown rates, haircuts, inflow rates and rollover limits.
4Compute stressed outflows and inflows for each horizon, then the net outflow.
5Value the buffer after haircuts and exclude assets that are encumbered or cannot be monetised in time.
6Compare buffer and net outflow, and state the surplus, shortfall or survival horizon.
7Link to action: which EWI or trigger would escalate, and which CFP source would close a gap.
8Check the answer against the wording, for example 'most severe' or 'least reliable source'.

Quickest way: Four-line check for stress and CFP questions

When to use it: Use when time is short and options are conceptual or involve a simple buffer comparison.

Severity ranking: combined > market-wide or idiosyncratic alone.
Funding quality: retail insured deposits are the most stable; short-term unsecured wholesale is the least stable.
Buffer: take assets after haircut, then subtract net outflows.
CFP test: if a source is not tested, not available quickly or not pre-positioned, it is the weak link.

Common mistakes in Liquidity Stress Testing and Contingency Funding Plans

Using market value of assets as the buffer instead of value after haircuts.
Students focus on the outflow side and forget stressed asset values.
Fix: Always apply the haircut first, then compare with net outflows.
Treating a CFP as the same thing as a stress test.
Both are used in liquidity crises, so they seem alike.
Fix: Stress tests measure the size and speed of the gap. The CFP states what you do to close it.
Assuming all funding runs off at the same rate.
Simple examples use one rate.
Fix: Match run-off to funding type, counterparty and insurance. Wholesale unsecured runs faster than stable retail.
Counting central bank facilities as unlimited, certain funding in the CFP.
Students assume the lender of last resort always helps.
Fix: Treat them as contingent. Check collateral eligibility, pre-positioning and stigma risk.
Choosing a mild, single-cause scenario as the best test.
Plausible is confused with mild.
Fix: Scenarios should be severe but plausible. Combined stress is stronger than either part alone.
Setting early warning indicators without thresholds or owners.
Lists of indicators look complete.
Fix: An EWI is only useful with a threshold, an escalation path and regular monitoring.

Worked examples

Example 1

A bank's counterbalancing capacity after haircuts is $600 million. Projected cumulative net outflows under a combined stress are $150 million at day 7, $380 million at day 14, $590 million at day 21 and $820 million at day 30. Find the survival horizon among these dates, and say what the CFP should do.

Show the solution

Day 7: 150 ≤ 600, survives.
Day 14: 380 ≤ 600, survives.
Day 21: 590 ≤ 600, survives with $10 million left.
Day 30: 820 > 600, shortfall of $220 million.
The buffer is first breached at the day 30 observation, the first date where cumulative net outflow exceeds capacity. The bank last survives at day 21, so the survival horizon among these dates is about 21 days. The actual breach occurs between day 21 and day 30.
The CFP should have triggers well before day 21 and contingent sources of at least $220 million, such as secured borrowing, asset sales or central bank facilities, that are operationally ready.

Answer: The buffer is first breached at day 30, so the bank survives through day 21. The survival horizon among these dates is about 21 days, with the breach falling between day 21 and day 30. There is a $220 million shortfall at day 30 that the CFP must cover with ready, tested contingent funding.

Exam tips

Read for the scenario type. Questions often ask which scenario is most severe or best captures a given weakness.
Expect applied calculations with run-off rates and haircuts. Do the buffer after haircuts first.
For CFP questions, look for the realistic, actionable option: tested, pre-positioned, clearly owned.
For indicators, pick signals that are forward-looking and have thresholds, and distinguish bank-specific from market-wide ones.
Reverse stress testing begins with the failure outcome, not with a given shock.

Practice questions from Monitoring Liquidity

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.

Liquidity Stress Testing and Contingency Funding Plans: frequently asked questions

What are the main components of a contingency funding plan?

A CFP has governance and crisis team roles, early warning indicators and triggers, stress scenarios, a list of contingent funding sources, communication plans and regular testing. Each source should state size, speed and conditions for use.

What are examples of early warning indicators for liquidity risk?

Examples are falling deposits, rising wholesale funding costs, widening CDS spreads, a falling share price, shorter funding tenors, more collateral calls and rating downgrades. They are bank-specific or market-wide and each needs a threshold.

How do you design a liquidity stress test for a bank?

Choose idiosyncratic, market-wide and combined scenarios that fit the business model. Set run-off, drawdown, rollover and haircut assumptions, project net cash flows over several horizons, and compare them with the buffer. Then review results with senior management.

What is reverse stress testing in liquidity risk?

It starts with an outcome such as exhausting the liquidity buffer and works backwards to find the events that could cause it. It helps find weaknesses that standard scenarios miss.