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

In a liquidity stress test, why should a bank incorporate second-round effects such as the impact of its own asset sales on market prices?

Second-round effects matter because large asset sales in stressed markets depress prices and widen spreads, so the cash raised is less than normal valuations suggest. Scenarios should therefore apply larger stressed haircuts and consider market depth when estimating the liquidity generated from the liquidity buffer.

  1. ABecause asset sales always generate accounting gains that offset outflows
  2. BBecause regulators prohibit assuming that assets can be sold at book value
  3. CBecause selling large volumes in stressed markets can depress prices and reduce the liquidity generated, so haircuts should be larger than in normal conditionsCorrect
  4. DBecause second-round effects reduce the contractual maturity of liabilities

Explanation

In stress, simultaneous selling by many institutions lowers prices and widens bid-ask spreads, so counterbalancing capacity is lower than at normal market values. Scenarios should apply stressed haircuts and consider market depth.

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