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FRM Part II · FRM Exam Part II · Early Warning Indicators

A bank's EWI for retail deposit run-off has historically produced many alerts that did not precede any actual liquidity stress. Management is concerned about the indicator's reliability. Which statement best describes this limitation and an appropriate response?

The problem is false positives, where alerts occur without actual stress. Management should recalibrate thresholds and combine the indicator with others, balancing sensitivity against false alarms. Lowering thresholds would worsen the problem, and relying only on backward-looking ratios would remove the early warning function.

  1. AThe indicator suffers from false positives; management should recalibrate thresholds and combine it with other indicators, balancing sensitivity against false alarmsCorrect
  2. BThe indicator suffers from false negatives; management should lower thresholds further to catch more events
  3. CThe indicator is invalid and should be replaced by backward-looking accounting ratios only
  4. DThe alerts show the bank is over-hedged and should reduce its liquidity buffer

Explanation

Alerts without subsequent stress are false positives. Tightening thresholds further would increase them, so the response is recalibration, backtesting and combining with other signals. Dropping to purely backward-looking ratios would reduce the early warning value.

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