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

A bank's supervisor reviews a CCAR-style submission. The bank's baseline plan assumes the balance sheet grows strongly, with loans expanding 15% a year, while the supervisory severely adverse scenario shows a deep recession. The bank keeps the same growth in the stressed projection and reports a comfortable capital ratio. What is the principal weakness of this approach?

The main weakness is inconsistency with the scenario: assuming strong loan growth during a deep recession ignores weak demand and funding constraints and can flatter projected revenue and capital. Supervisors expect balance sheet and business assumptions that reflect the severity of the stressed environment.

  1. AUsing a growing balance sheet in stress is conservative, so it overstates losses
  2. BAssuming growth in a deep recession is inconsistent with the scenario and implicitly assumes access to funding and demand that may not exist, flattering projected capital ratios if new lending is profitableCorrect
  3. CStress tests never allow balance sheet assumptions to differ from the baseline
  4. DThe approach ignores only the dividend assumption, which is the sole issue

Explanation

Supervisory tests require projections consistent with the scenario. Strong growth in a severe recession is implausible given weak demand and funding strains, and the new business would add revenue assumptions that mask losses. It is not conservative; the claim of banning differences from baseline is false, and dividends are not the main issue.

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