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FRM Part II · FRM Exam Part II · Liquidity Risk

A bank's treasurer is designing a liquidity stress test. Which scenario design is most consistent with sound practice for assessing the bank's resilience to a combined shock?

The best design combines bank-specific and market-wide shocks, with runoff, wholesale funding loss and reduced asset marketability across several time horizons. Single-factor, average-based or central-bank-dependent scenarios fail to capture the interacting effects that actually drive liquidity crises.

  1. AA single idiosyncratic scenario in which only the bank's own credit rating is downgraded, with market conditions assumed normal
  2. BA scenario combining bank-specific and market-wide stresses, with assumptions on deposit runoff, loss of wholesale funding and reduced asset marketability over multiple time horizonsCorrect
  3. CA scenario that assumes the central bank will immediately provide unlimited funding, so that no outflows need to be modelled
  4. DA scenario based only on the average daily net outflow observed over the past year

Explanation

Sound stress testing uses severe but plausible scenarios that combine idiosyncratic and market-wide shocks and assess several horizons. A single idiosyncratic shock understates interaction effects such as lower asset liquidity. Assuming central bank support or using averages removes the stress element.

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