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

A bank's stress testing committee wants a scenario that identifies which combinations of events would cause the bank to breach its minimum capital requirement and become non-viable. Which approach best meets this objective?

Reverse stress testing is best. It begins with the unacceptable outcome, such as breaching minimum capital, and works backward to identify the events and combinations that could cause it, uncovering vulnerabilities that forward-looking historical or single-factor scenarios may not reveal.

  1. AReverse stress testing starting from the non-viability outcome and working back to the causing eventsCorrect
  2. BReplaying the worst quarter in the bank's own loss history
  3. CShocking only the interest rate factor by 200 basis points
  4. DUsing the regulator's supervisory baseline scenario unchanged

Explanation

Reverse stress testing fixes an adverse outcome, such as capital falling below the minimum, and searches for scenarios producing it. This reveals vulnerabilities that forward scenarios may miss. The other choices do not start from the failure point, and a baseline scenario is not adverse.

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