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

A bank wants its stress testing to uncover scenarios that would breach its minimum capital ratio and make the business model unviable, without assuming a scenario in advance. Which approach is most appropriate?

Reverse stress testing is the best fit. It begins with the outcome of concern, such as breaching minimum capital or business model failure, and works backward to find the scenarios that could cause it, revealing vulnerabilities that predetermined historical or uniform-shock scenarios may miss.

  1. AReplaying the worst historical quarter in the data
  2. BApplying a uniform 10% shock to all risk factors
  3. CReverse stress testing that starts from the failure outcome and works back to the causal scenariosCorrect
  4. DIncreasing the VaR confidence level from 99% to 99.9%

Explanation

Reverse stress testing defines an unacceptable outcome, such as breaching minimum capital, and identifies the combinations of events that lead there. This exposes vulnerabilities not anticipated by chosen scenarios. Historical replay and uniform shocks presuppose the scenario, and a higher VaR confidence level is still a statistical measure of normal-type conditions.

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