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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 the bank assumes it can sell its entire portfolio of corporate bonds at pre-stress prices within five days under a combined market-wide and idiosyncratic scenario. Which criticism is most consistent with supervisory expectations?

The key criticism is that the bank ignores deteriorating market liquidity under stress. Asset monetization assumptions should reflect stressed haircuts, price impact and realistic time to sell, particularly in a combined scenario, rather than assuming sales at pre-stress prices within days.

  1. AThe assumption is acceptable provided the bonds are investment grade
  2. BThe assumption ignores that market liquidity and haircuts deteriorate under stress, so asset monetization should reflect stressed haircuts and time to sellCorrect
  3. CThe test should assume bonds cannot be sold at all in any scenario
  4. DThe bank should instead assume bond sales generate inflows in excess of outflows

Explanation

Supervisors expect stress tests to reflect reduced market liquidity, wider haircuts and delays in monetizing assets, especially in combined scenarios. Assuming no sale at all is overly extreme and not required; investment grade status does not eliminate stressed haircuts.

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