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

A bank's stress test shows a survival horizon of 30 days under a combined idiosyncratic and market-wide scenario. Management proposes to extend it by moving buffer assets into a structure that raises the yield but reduces market depth. Which assessment is most appropriate?

The proposal is questionable because reduced market depth raises stressed haircuts and monetisation time, shrinking the usable buffer and survival horizon. Liquidity buffers are valued by their reliable convertibility to cash in stress, not by nominal size or yield.

  1. AAcceptable, because yield enhancement offsets haircuts and the survival horizon is unaffected
  2. BAcceptable, because the buffer size in nominal terms is unchanged
  3. CUnacceptable only if the assets are denominated in a foreign currency
  4. DQuestionable, because lower market depth is likely to raise stressed haircuts and monetisation time, reducing the usable buffer and the survival horizon in stressCorrect

Explanation

Counterbalancing capacity is judged by what can be monetised quickly in stress, not nominal value. Less market depth means larger haircuts and slower sales, so the usable buffer shrinks. Yield does not offset this, and nominal size is not the test.

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