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

A bank's stress-testing team projects the effect of a severely adverse scenario on its capital ratio. Which of the following correctly describes the usual sequence of the capital projection?

Projected capital equals starting capital plus pre-provision net revenue, less losses and provisions, taxes and planned distributions. Revenue capacity offsets part of the stressed losses, so a sound projection includes both sides rather than deducting losses alone.

  1. AStarting capital plus projected pre-provision net revenue, minus projected losses and provisions, minus taxes and planned distributions, gives projected ending capitalCorrect
  2. BStarting capital minus projected losses, with revenue assumed to be zero and taxes ignored, gives projected ending capital
  3. CStarting capital plus projected losses, minus pre-provision net revenue, gives projected ending capital
  4. DStarting capital minus gross revenue, plus provisions, gives projected ending capital

Explanation

Capital projections roll forward starting capital by adding earnings capacity (PPNR) and deducting credit and other losses, provisions, taxes and capital distributions. Ignoring revenue, as in the second option, overstates the capital depletion and is not the standard approach.

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