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FRM Part II · FRM Exam Part II · Liquidity Stress Testing

A bank's treasury is designing a liquidity stress test. The risk committee asks why the test should include both an idiosyncratic scenario and a market-wide scenario instead of only one. Which response is most consistent with sound scenario design?

Both are run because they stress different channels: idiosyncratic scenarios test loss of confidence in the specific firm, while market-wide scenarios test impaired asset marketability and funding markets. A combined scenario is typically most severe, so using only one would leave important vulnerabilities untested.

  1. AA market-wide scenario alone is enough, because firm-specific events are always captured by it
  2. BAn idiosyncratic scenario alone is enough, because market-wide shocks only affect the asset side
  3. CThe two scenarios produce identical outflows, so running both is only a documentation exercise
  4. DThe two scenarios stress different channels, such as loss of confidence in the firm versus impaired asset liquidity and funding markets, and the combined case is typically the most severeCorrect

Explanation

Idiosyncratic events hit the firm's own funding (for example, rating downgrade and deposit runs), while market-wide events hit market liquidity and haircuts across institutions. Their effects differ, and a combined scenario usually produces the most severe stress. Relying on only one leaves channels untested.

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