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

A bank's stress scenario assumes a severe recession but keeps funding spreads, counterparty defaults and operational losses at baseline levels, and assumes management will quickly raise capital and sell assets at book value. A reviewer criticizes the design. Which criticism is most valid under good scenario design practice?

The most valid criticism is that the scenario is internally inconsistent and ignores interactions between risks, while assuming unrealistic management actions. In a severe recession, funding, counterparty and operational stresses typically worsen together, and capital raising or asset sales at book value are unlikely in such conditions.

  1. AThe scenario is too severe because recessions never affect funding
  2. BThe scenario lacks internal coherence and interaction of risks, and relies on unrealistic management actionsCorrect
  3. CThe scenario should have used only a single risk factor to be transparent
  4. DThe scenario is acceptable because baseline assumptions improve comparability

Explanation

Good scenarios should capture the interaction of risk types (credit, market, liquidity, operational) that tend to worsen together in stress, and should avoid optimistic assumptions such as unconstrained capital raising or asset sales at book value. Holding other variables at baseline in a severe recession is inconsistent. Single-factor design would reduce, not improve, realism.

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