FRM Part I · FRM Exam Part I · Stress Testing
A bank's stress test shows that a severe scenario would reduce its CET1 ratio from 12.0% to 8.5%. Management proposes to ignore the result because the scenario probability is judged to be extremely low. Which response best reflects sound use of stress testing in risk management?
Management should keep the result, judge the scenario on plausibility rather than a narrow probability cutoff, and consider mitigating actions or capital buffers if the loss breaches risk appetite. Stress tests exist to expose vulnerabilities in tail events that statistical measures such as VaR may miss.
- AAccept the proposal, because stress tests are only meaningful for scenarios with a quantified probability above 1%
- BReplace the scenario with a 99% VaR estimate, which has a defined probability
- CRetain the result, assess plausibility rather than probability alone, and consider mitigating actions or buffers if the loss would breach risk appetiteCorrect
- DReduce the scenario severity until the CET1 ratio stays above 12%
Explanation
Stress scenarios are meant to be severe but plausible and to reveal vulnerabilities that VaR-style probabilities do not capture. Dismissing results on low probability alone defeats the purpose. Tuning severity to keep the ratio unchanged makes the test meaningless.
Did you get it right without looking?
One question tells you little. A timed set on Stress Testing shows your real accuracy, how long you take and where you lose marks.
More Stress Testing questions
- Which statement about using stress testing alongside VaR is most accurate?
- A bank's stress test applies a severe equity market fall but assumes that correlations between asset classes stay at their long-run averages…
- A bank starts a stress test with CET1 capital of $60 billion and risk-weighted assets (RWA) of $500 billion. Over the nine-quarter horizon, …
- A risk manager notes that a stress test using historical scenarios, such as the 2008 crisis, may fail to capture future vulnerabilities. Whi…
- Under the EBA EU-wide stress test methodology, which feature is most characteristic of how the exercise is run?
- A supervisor designs the severely adverse scenario for a regulatory stress test. Which design choice is most consistent with the purpose of …