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FRM Part II · FRM Exam Part II · Liquidity Risk Reporting and Stress Testing

A bank's treasury team is designing its liquidity stress testing framework. Which scenario design best captures the idea that liquidity stress can arise from both institution-specific and market-wide causes?

The best design uses idiosyncratic, market-wide and combined scenarios across multiple horizons. Liquidity stress can originate inside the bank or in markets, and combined shocks are typically most severe, so a single-factor or averaged-history scenario fails to capture these different channels and timings.

  1. AA single scenario based only on a one-notch rating downgrade of the bank
  2. BA set of scenarios covering an idiosyncratic shock, a market-wide shock, and a combined shock, each run over several time horizonsCorrect
  3. CA scenario that only increases retail deposit outflows by a fixed percentage
  4. DA scenario based on the average of past quarterly cash flow gaps

Explanation

Sound frameworks use idiosyncratic, market-wide and combined scenarios across multiple horizons because liquidity stress has different sources and speeds. A single-factor or historical-average scenario ignores the interaction of funding and market liquidity shocks.

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