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

A bank's stress test relies on a single scenario based on a repeat of the most severe historical recession in its home market. Which weakness of this design is most important from a stress testing governance perspective?

The key weakness is that history may not reflect current portfolio exposures or emerging vulnerabilities, so relying on one past event leaves blind spots. Sound programs add forward-looking hypothetical scenarios tailored to the bank's present risks, rather than depending only on a historical replay.

  1. AHistorical scenarios cannot be expressed in terms of macroeconomic variables
  2. BPast events may not capture new vulnerabilities, so the scenario set should also include forward-looking hypothetical scenariosCorrect
  3. CHistorical scenarios always overstate losses compared with hypothetical ones
  4. DHistorical scenarios are prohibited under supervisory guidance

Explanation

Historical scenarios are credible and easy to explain but are backward-looking, so they may miss emerging risks, changed portfolio composition or new risk interactions. A sound program supplements them with hypothetical, forward-looking scenarios. They can be expressed in macro variables and are not prohibited.

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