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

A bank's integrated stress test assumes a severe recession. Which modeling choice would MOST likely cause the bank to UNDERSTATE total stressed losses?

Aggregating stand-alone losses while assuming zero correlation, or diversification benefit, would most likely understate total stressed losses. In a severe recession credit, market and other losses are driven by the same shock and occur together, so ignoring this common driver and the feedback effects misstates the combined impact.

  1. ALinking falling asset prices to higher funding costs and reduced revenue
  2. BAggregating stand-alone risk-type losses assuming zero correlation between themCorrect
  3. CAllowing RWAs to rise as credit ratings migrate downward
  4. DIncluding second-round effects such as counterparty defaults

Explanation

Under a single stress scenario, losses across risk types tend to occur together. Treating them as independent or diversifying them ignores this common driver and understates the total. The other choices add feedback or capital pressure and would raise estimated losses or capital needs.

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