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FRM Part II · FRM Exam Part II · Early Warning Indicators

A bank's treasury team is designing an early warning indicator (EWI) framework for liquidity risk. Which design feature best allows the indicators to function as genuinely forward-looking signals rather than confirmations of a crisis already under way?

The best design uses indicators that move ahead of balance-sheet stress, such as market funding spreads and counterparty behavior. Metrics tied to regulatory breaches or audited annual statements are lagging, so they confirm stress already present instead of warning early enough for management to act.

  1. ASelecting indicators that move before funding stress reaches the bank's own balance sheet, such as market-wide funding spreads and changes in counterparty behaviorCorrect
  2. BUsing only indicators based on the bank's reported month-end liquidity coverage ratio
  3. CSetting thresholds at the level at which the bank would already breach its regulatory minimum
  4. DLimiting the framework to indicators that are easy to compute from audited annual statements

Explanation

Leading indicators capture external and behavioral signals (market spreads, counterparty reactions, wholesale funding availability) that tend to deteriorate before internal metrics do. Metrics tied to regulatory minimums or audited annual data are lagging and confirm stress after it has occurred.

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