How should I define the loss threshold for a reverse stress test?

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AcadiFi · Accepted Answer

Defining the threshold is the most important decision in a reverse stress test because it determines whether the exercise is actionable. Three threshold families are common.

First, capital-based: loss that consumes CET1 down to the prudential minimum including buffers. For a bank with 13% CET1 ratio and a 10.5% combined requirement, losses that erode 250bp would cross the threshold. Translate to dollars by multiplying the shortfall by RWA.

Second, liquidity-based: an outflow pattern under which the LCR breaches 100% even with contingency funding actions, or the NSFR collapses. This often binds before capital for wholesale-funded firms.

Third, franchise-based: loss of a critical counterparty relationship (e.g., primary clearing bank, top three prime brokerage clients, rating downgrade below investment grade triggering CSA collateral calls and contractual termination rights).

A hybrid firm-wide threshold might be defined as the minimum of: (a) CET1 below 8%, (b) LCR below 100% over 30 days, (c) credit rating below BBB-. Once defined, the threshold becomes the target loss surface the scenarios must reach.

For FRM exam, note that European Banking Authority guidelines emphasize that the threshold must be approved by the board and reviewed annually. The threshold should NOT be a one-in-one-thousand-year loss — it should be a plausible breach point whose remedies can be rehearsed. Recovery trigger levels are typically set above the reverse stress threshold to preserve optionality.

How should I define the loss threshold for a reverse stress test?

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