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FRM Part II · FRM Exam Part II · Stress Testing Banks

A bank complements its scenario-based enterprise stress tests with a reverse stress test. What does the reverse stress test do?

A reverse stress test starts from a defined adverse outcome, such as capital falling below the minimum or the business model failing, and identifies the scenarios that could cause it. This exposes hidden vulnerabilities that forward-looking scenarios might not reveal.

  1. AStarts from a defined failure outcome and identifies scenarios that could cause itCorrect
  2. BReverses the sign of the baseline forecast to create the adverse case
  3. CTests only the most probable scenario
  4. DBack-tests the bank's VaR model against realized losses

Explanation

A reverse stress test begins with an outcome such as breaching minimum capital or business model failure, then works backward to find the events that would cause it. This reveals vulnerabilities that forward scenarios may miss. It is not VaR backtesting or a sign flip.

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