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

A risk committee is reviewing the design of its reverse stress test. After identifying a plausible combination of events that exhausts the buffer in 10 days, the committee decides the scenario is too unlikely to matter. What is the main flaw in this conclusion?

The flaw is that reverse stress testing aims to expose vulnerabilities and challenge the business model, limits and contingency plans, rather than being judged on likelihood alone. A plausible scenario that exhausts the buffer in 10 days should prompt management action, not dismissal.

  1. AReverse stress tests should only be used for capital, not liquidity
  2. BThe purpose is to reveal vulnerabilities and test whether the business model and limits remain appropriate, not to be dismissed on probability aloneCorrect
  3. CPlausible scenarios must always be assigned a probability above 5% before use
  4. DThe scenario should have exhausted the buffer in under 24 hours to be relevant

Explanation

Reverse stress testing is designed to expose hidden vulnerabilities and inform risk appetite, limits and contingency planning. Dismissing a plausible scenario on low probability ignores that purpose. No required probability threshold or one-day horizon exists.

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