Skip to content

FRM Part II · FRM Exam Part II · Liquidity Stress Testing

A bank designs a liquidity stress scenario that combines a credit rating downgrade, a run-off of uninsured deposits and a sharp rise in haircuts on repo collateral. Which statement best describes why such a combined scenario is more useful than testing each factor in isolation?

A combined scenario is more useful because liquidity drivers interact and amplify one another, for example a downgrade triggering collateral calls and deposit flight. Testing factors alone, or assuming independence and diversification, would understate the total cash outflow and survival risk.

  1. ALiquidity shocks are independent, so combining them lowers the estimated total outflow through diversification
  2. BCombined scenarios are used only to compute regulatory capital and not cash flows
  3. CLiquidity risk drivers interact and reinforce each other, so a combined scenario captures second-round effects such as collateral calls triggered by the downgradeCorrect
  4. DSingle-factor tests are prohibited by supervisors

Explanation

In stress periods, funding, market and contingent drivers are correlated and feed each other, for example a downgrade triggers collateral calls and deposit flight. Assuming independence understates outflows, so the diversification claim is wrong. Single-factor tests are not prohibited; they are useful as sensitivities.

Did you get it right without looking?

One question tells you little. A timed set on Liquidity Stress Testing shows your real accuracy, how long you take and where you lose marks.

Practise Liquidity Stress TestingFree diagnostic mock

More Liquidity Stress Testing questions