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

When selecting the severity of a stress scenario for an enterprise-wide stress test, which approach best aligns with supervisory expectations?

Scenarios should be severe but plausible and regularly challenged so that design does not anchor on recent benign experience. Stress testing aims to expose vulnerabilities in tail events, so choosing only likely events, easily survivable ones or the mildest scenario would defeat its purpose.

  1. AChoose scenarios that are severe but plausible, and challenge them regularly to avoid anchoring on recent experienceCorrect
  2. BChoose only scenarios with a historical probability above 5%
  3. CChoose scenarios that the bank is certain it can survive
  4. DChoose the mildest scenario to avoid unnecessary management actions

Explanation

Supervisors expect scenarios to be exceptional yet plausible, tailored to the bank's vulnerabilities, and reviewed to avoid complacency from recent benign conditions. Limiting scenarios to likely events or ones the bank surely survives defeats the purpose of stress testing, which is to reveal vulnerabilities in tail events.

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