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

A bank's treasury team is designing a liquidity stress test. Which scenario design is most consistent with good practice for capturing the interaction between firm-specific and market-wide effects?

The best design is a combined scenario where a firm-specific event, such as a rating downgrade, occurs alongside market-wide funding disruption. Real liquidity crises involve both effects reinforcing each other, whereas single-factor, mild, or average-based scenarios understate the severity and interactions the stress test needs to capture.

  1. AA combined scenario in which a credit rating downgrade coincides with disruption in wholesale funding and repo marketsCorrect
  2. BA scenario that only assumes a modest, temporary increase in retail deposit withdrawals
  3. CA scenario based solely on the bank's average daily cash outflows over the past year
  4. DA scenario in which only the bank's largest single counterparty fails to roll over funding

Explanation

Good practice calls for scenarios that combine idiosyncratic and market-wide shocks, because in real crises they reinforce each other (a downgrade reduces access just when markets are impaired). The other options are narrow, benign, or based on normal-day averages and so understate stress.

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