FRM Part II · FRM Exam Part II · Liquidity Risk
A bank's treasurer is drafting the liquidity stress testing framework. Which design choice best reflects sound practice for the scenarios used?
Good practice uses several scenarios covering idiosyncratic, market-wide and combined shocks, with varying severity and duration. History alone or a single short shock leaves gaps, and off-balance-sheet commitments must be included because they can draw down in stress and drain liquidity.
- AUse only historical bank-specific events, since hypothetical scenarios cannot be calibrated
- BCombine idiosyncratic and market-wide shocks, including a combined scenario, and vary severity and durationCorrect
- CUse a single severe market-wide scenario lasting one day, to keep results comparable over time
- DExclude contingent off-balance-sheet exposures because they are not currently on the balance sheet
Explanation
Sound liquidity stress testing uses multiple scenarios: idiosyncratic, market-wide and combined, at varying severity and horizons. Relying only on history or a single one-day shock misses plausible vulnerabilities. Contingent exposures such as committed facilities can draw down under stress and must be included.
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