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

The EU-wide stress test coordinated by the European Banking Authority is described as a constrained bottom-up exercise. What does this mean in practice?

Constrained bottom-up means banks produce projections with their own models and data, but must apply a common methodology, prescribed scenarios and restrictions, and supervisors review and challenge the results. This balances bank-specific granularity with comparability across institutions.

  1. ABanks design their own scenarios and methods without any supervisory constraints
  2. BSupervisors compute all results centrally without bank input
  3. CBanks run the projections using their own models, but within a common methodology, prescribed scenarios and constraints, with supervisory review and quality assurance of resultsCorrect
  4. DOnly the balance sheet is projected, and it is assumed to shrink each year

Explanation

Banks use their internal models and data, but must follow a common methodology and scenarios with floors and restrictions, and national supervisors and the EBA challenge the results. This supports comparability. The top-down-only and unconstrained descriptions are wrong, and the EBA exercise typically assumes a static balance sheet, not shrinking.

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