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

A bank's treasury team runs a liquidity stress test and finds that the bank survives all prescribed scenarios with a comfortable buffer. The Chief Risk Officer asks for a reverse stress test. Which description best captures the starting point of a reverse liquidity stress test?

A reverse liquidity stress test starts by defining a failure point, such as the liquidity buffer being exhausted, and then works backward to find which shocks or scenarios would cause it. It is not a forward test of prescribed scenarios, which is why it can reveal hidden vulnerabilities.

  1. AApply the 30-day LCR outflow rates to the current balance sheet and compute the resulting ratio
  2. BDefine a failure outcome, such as exhaustion of the liquidity buffer, and identify the scenarios that would produce itCorrect
  3. CRepeat the most severe historical scenario with the shocks scaled up by a fixed multiple
  4. DReduce the scenario horizon until the bank passes every test

Explanation

Reverse stress testing begins from an unacceptable outcome, such as the buffer being fully used or the survival horizon being breached, and works backward to find the combinations of shocks that cause it. The LCR option is a forward, prescribed test. Scaling a historical scenario is still a forward-looking test rather than one that starts from failure.

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