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FRM Part II · FRM Exam Part II · Monitoring Liquidity

In a liquidity stress test, a bank assumes a 30-day horizon with deposit outflows, loss of secured funding and draws on committed credit lines. Which approach best reflects a sound treatment of the interaction between these effects?

A sound stress test uses a combined scenario where deposit runoff, secured funding losses and credit line draws occur together and reinforce each other, including second-round effects like higher haircuts. Treating them independently or ignoring off-balance-sheet draws understates the shortfall.

  1. AModel them as independent events and sum the average outcomes
  2. BUse a scenario in which the effects occur together and reinforce each other, including second-round effects such as haircut increasesCorrect
  3. CApply only the largest single outflow
  4. DExclude off-balance-sheet draws because they are contingent

Explanation

Liquidity stresses are correlated and self-reinforcing: collateral haircuts rise, credit lines are drawn, and funding withdraws simultaneously. Independent or single-factor treatments understate the shortfall, and excluding off-balance-sheet draws ignores a major stress channel.

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