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

A reverse stress test at a mid-sized bank shows that the buffer would be exhausted only if a rating downgrade, loss of secured funding on lower-quality collateral and a sharp drawdown of committed credit lines occurred together within 10 days. Management argues the scenario is too remote to act on. What is the best risk management view?

Management should evaluate how plausible the combined shocks are, given their interdependencies, and take mitigating actions such as diversifying collateral or limiting committed lines where the vulnerability is material. Dismissing the scenario as remote defeats the purpose of reverse stress testing, which is to reveal hidden weaknesses.

  1. AAgree, because reverse stress scenarios with low probability should be excluded from the process
  2. BAssess the plausibility of the combination and its interdependencies, and consider mitigants such as collateral diversification or line limits where the vulnerability is materialCorrect
  3. CReplace the scenario with a single-factor shock, which is more transparent
  4. DIncrease the VaR confidence level to 99.9% to capture the event

Explanation

Reverse stress tests aim to expose vulnerabilities and are not assigned probabilities. Management should judge plausibility and act on material, interlinked vulnerabilities. Dismissing them removes their value, and VaR is not the relevant tool for liquidity survival.

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