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FRM Part II · FRM Exam Part II · Stress Testing Banks

During an enterprise-wide stress test, a bank's model shows that in a severe recession falling asset prices force it to sell securities, which depresses prices further and raises funding costs, which in turn increases credit losses. Which feature of integrated stress testing does this illustrate?

This illustrates second-round feedback effects linking market, liquidity and credit risk. Asset sales depress prices, raise funding costs and increase credit losses in a loop, something an integrated enterprise-wide stress test can capture but a siloed or static balance sheet approach cannot.

  1. AReverse stress testing of the business model
  2. BBack-testing of the trading book VaR
  3. CSecond-round feedback effects between market, liquidity and credit riskCorrect
  4. DStatic balance sheet assumption

Explanation

The described loop of fire sales, price declines, funding cost increases and credit losses is a feedback or second-round effect captured only in an integrated framework. A static balance sheet ignores management actions and such dynamics, so it is the opposite of what is described.

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