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

A bank wants to find out which combinations of events would cause it to fail, without first specifying a scenario. Which approach does this describe, and what is its main characteristic?

This is reverse stress testing. It starts from a predefined failure outcome, such as breaching minimum capital, and works backward to identify the combinations of events that could cause it. Sensitivity, historical and backtesting approaches all start from a specified shock or compare model output to results.

  1. AReverse stress testing, which starts from a defined adverse outcome such as breaching capital requirements and works back to the scenarios causing itCorrect
  2. BSensitivity analysis, which shocks one risk factor by a fixed amount
  3. CHistorical scenario analysis, which replays a past crisis exactly
  4. DBacktesting, which compares VaR with realized profit and loss

Explanation

Reverse stress testing begins with the outcome, such as insolvency or a capital breach, and identifies the scenarios that lead there. Sensitivity analysis and historical replay both begin from a specified shock, and backtesting evaluates VaR models.

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