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FRM Part II · FRM Exam Part II · Liquidity Stress Testing

A bank's liquidity risk team conducts a reverse stress test. Which description best captures the starting point and purpose of this exercise?

A reverse stress test starts from a predefined failure outcome, like the liquidity buffer running out, and works backward to identify the scenarios and assumptions that would produce it. This differs from forward tests that start with a shock and measure impact, and it helps uncover hidden vulnerabilities.

  1. AIt begins with a defined failure outcome, such as exhaustion of the liquidity buffer, and identifies the scenarios that could cause itCorrect
  2. BIt begins with a historical crisis and replays the observed outflows exactly
  3. CIt begins with a regulatory ratio such as the LCR and confirms it exceeds 100%
  4. DIt begins with the most likely market scenario and estimates expected profit

Explanation

Reverse stress testing works backward: it fixes an unacceptable outcome, such as the buffer being depleted or a survival horizon being breached, and then finds the combinations of shocks that lead to it. Historical replay and ratio checks are forward-looking or compliance exercises. Expected-case analysis is not stress testing.

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