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FRM Part II · FRM Exam Part II · Liquidity Risk

A bank's stress test shows it survives 30 days under the baseline stress scenario. Management proposes to rely on the results without further analysis. Which additional step best strengthens the test's usefulness for risk management?

Reverse stress testing is the best additional step: it begins with the point where the liquidity buffer is exhausted and works back to the combinations of events that would cause it, challenging assumptions and revealing hidden vulnerabilities beyond a single baseline scenario.

  1. AIncrease the assumed inflows from loan repayments so the result looks stronger
  2. BRun reverse stress tests to identify the conditions that would exhaust the liquidity buffer, and use them to challenge assumptionsCorrect
  3. CRemove market-wide shocks since they are outside management control
  4. DReport results only to the treasury department to avoid alarm

Explanation

Reverse stress testing starts from the failure outcome and identifies the scenarios causing it, exposing vulnerabilities not seen in prescribed scenarios. Increasing inflows or removing shocks weakens the test, and limiting reporting undermines governance.

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