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

A supervisor reviews a bank's liquidity stress test and finds that management assumes all of the bank's high-quality liquid securities can be sold at their pre-stress market prices within the first week of a combined market-wide and idiosyncratic stress. What is the most appropriate supervisory criticism?

The supervisor should criticise the assumption because under stress securities face wider haircuts, lower prices and limited market depth, so sale proceeds would fall below pre-stress values. This overstates the bank's counterbalancing capacity. Book classification does not make assets more liquid, and assuming zero sales is unrealistic.

  1. AThe assumption ignores haircuts and market depth that would reduce proceeds under stress, so counterbalancing capacity is likely overstatedCorrect
  2. BThe assumption is overly conservative because liquid securities never lose value
  3. CThe assumption is acceptable provided the securities are held in the banking book
  4. DThe assumption should be replaced with the assumption that no securities can be sold at all

Explanation

In stress, market prices fall and haircuts widen, and selling large volumes moves prices, so proceeds are lower than pre-stress values. The criticism is that counterbalancing capacity is overstated. Assuming no sales at all is not a realistic requirement, and accounting book classification does not change market liquidity.

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