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FRM Part II · FRM Exam Part II · Liquidity Stress Testing

In a liquidity stress test, a bank's projected cash flows for a retail term deposit book assume that depositors will not break deposits early because penalties apply. During a severe idiosyncratic stress scenario, which is the most important reason to challenge this assumption?

The assumption should be challenged because contractual terms do not guarantee behavior under stress. Depositors may accept penalties when confidence falls, and the bank may waive penalties to protect its reputation, so early outflows on term deposits can occur in a severe idiosyncratic scenario.

  1. AContractual maturity may not reflect behavior, as depositors may accept penalties or the bank may waive them to protect its reputationCorrect
  2. BTerm deposits always mature earlier than contractual terms in all scenarios
  3. CPenalties increase the bank's cash outflows when deposits are broken
  4. DEarly withdrawal only occurs in market-wide, not idiosyncratic, stress

Explanation

Behavioral assumptions should be stress-sensitive: depositors may accept penalties in a confidence crisis, and banks may waive them to protect franchise value. The other options state false generalizations; penalties reduce, not increase, outflows.

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