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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 framework to function as a genuine early warning rather than a lagging report?

The best design uses forward-looking indicators that deteriorate before stress appears and sets thresholds that trigger escalation before limits or regulatory minimums are breached. This gives management lead time to act, whereas lagging indicators or thresholds at the minimum only confirm stress already underway.

  1. AUsing only indicators that move after the bank's funding costs have already risen sharply
  2. BSelecting indicators that tend to deteriorate before liquidity stress emerges, and setting thresholds that prompt escalation before limits are breachedCorrect
  3. CSetting thresholds equal to the regulatory minimum so breaches coincide with supervisory action
  4. DLimiting the framework to a single composite indicator reviewed annually

Explanation

An EWI is useful only if it signals deterioration ahead of actual stress, so thresholds must trigger escalation before hard limits or regulatory minimums are hit. Indicators that move after stress, or thresholds set at the regulatory minimum, give no lead time. Annual review of one metric is too infrequent.

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