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

A risk manager reviews a bank's stress scenario in which assumed runoff rates for wholesale funding are calibrated solely to the bank's own experience during the benign last five years. What is the principal weakness of this scenario design?

The main weakness is that benign-period data do not reflect stressed counterparty behaviour, so runoff assumptions are probably too optimistic. Effective scenarios should draw on past crises, peer experience and judgment to be severe yet plausible, rather than extrapolating from calm conditions.

  1. AIt is too severe to be plausible for management purposes
  2. BIt overstates the benefit of diversification across funding sources
  3. CIt relies on data that do not reflect stressed behaviour, so runoff assumptions are likely too optimisticCorrect
  4. DIt double counts inflows from maturing loans

Explanation

Calibrating to benign history understates how quickly counterparties withdraw in stress. Scenarios should be severe but plausible, informed by past crises, other institutions' experience and expert judgment, not just calm-period data.

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