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

A bank's integrated stress test sums the stressed losses from credit risk, market risk and operational risk calculated separately, with no interaction between them. Compared with an approach that models feedback effects between risk types under the same scenario, the simple sum most likely:

The simple sum most likely understates the true combined impact. In stress, risk types interact and create feedback and second-round effects that amplify losses, while diversification benefits tend to shrink. Adding separately computed losses ignores these amplification channels.

  1. AHas no systematic bias because losses across risk types always offset each other
  2. BOverstates losses because diversification benefits are always larger in stress
  3. CUnderstates the true combined impact if risk interactions and second-round effects amplify losses in stressCorrect
  4. DIs required by supervisors because feedback effects must not be modelled

Explanation

In stress, risks tend to interact: for example, falling asset prices raise funding costs and credit losses, which further reduce capital and market confidence. A simple sum ignoring these second-round effects and the amplification can understate the combined impact. Diversification benefits typically shrink, not grow, in stress.

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