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

A bank designs a severe scenario with a deep recession, but assumes equity prices fall sharply while credit spreads narrow and the currency strengthens. A reviewer criticises the scenario. What is the most appropriate criticism?

The main criticism is lack of internal consistency. In a deep recession, falling equities would normally coincide with widening credit spreads, so the assumed joint moves are implausible, which undermines the scenario's credibility and the reliability of the resulting loss estimates.

  1. AThe scenario lacks internal consistency because the risk factor moves are not plausible together in a recessionCorrect
  2. BThe scenario is too severe to be useful
  3. CThe scenario should use only historical data
  4. DThe scenario should shock one variable at a time

Explanation

Scenario design requires coherent, plausible joint movements of variables. Equity falls with tightening credit spreads in a deep recession is an unlikely combination. Severity itself is not the flaw, and design may be hypothetical. One-at-a-time shocks ignore correlations and would be less realistic.

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