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

A bank runs a reverse stress test. The risk team starts by defining that the bank's CET1 ratio falls from 12.0% to 7.0%, then works backward. Which statement best describes the output and value of this exercise?

A reverse stress test starts from a defined failure outcome, such as CET1 falling to 7.0%, and works backward to find the scenarios that could cause it. This exposes hidden vulnerabilities and business model weaknesses rather than estimating a probability.

  1. AIt estimates the probability that CET1 falls to 7.0% using a VaR model
  2. BIt identifies scenarios and combinations of events that could cause the specified outcome, exposing hidden vulnerabilities and weaknesses in the business modelCorrect
  3. CIt applies a standard supervisory scenario to compute the resulting CET1 ratio
  4. DIt reduces the need for forward-looking scenario analysis because it covers all outcomes

Explanation

Reverse stress testing begins with a defined adverse outcome (such as a capital breach) and searches for the scenarios that would produce it. It reveals vulnerabilities that forward scenarios might not suggest. It is not a probability estimate and does not replace other stress tests.

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