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P1.T4.801. Stress testing validation and the role of internal audit (Siddique)

Nicole Seaman

Director of FRM Operations
Staff member
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Learning objectives: Identify areas of validation and independent review for stress tests that require attention from a governance perspective. Describe the important role of the internal audit in stress testing governance and control. Identify key aspects of stress testing governance, including stress-testing coverage, stress-testing types and approaches, and capital and liquidity stress testing.

Questions:

801.1. Which of the following statements is TRUE about the role of validation in stress testing governance?

a. Stress that cannot be fully validated should not be used
b. Stress-test estimates should be continuously backtested against realized outcomes because quantitative backtest results are a common, critical validation metric
c. Expert-based judgement should be applied to ensure that test results are intuitive and logical, and to add additional perspective on stress-test performance
d. If a model fails to perform strongly in the data-rich environment of a baseline (e.g., good times) setting, then it cannot be trusted to estimate stressed outcomes


801.2. Which of the following statements is TRUE about the role of internal audit in stress testing governance?

a. Internal audit should independently assess each stress test used
b. Internal audit is the "first line of defense" in stress testing governance
c. Internal audit should have have full knowledge of all stress-test details
d. Internal audit should assess the expertise and roles and responsibilities of the staff involved in stress-testing activities


801.3. Key aspects of stress testing governance include coverage, types (and approaches) and capital/liquidity. Each of the following is true about these three general aspects EXCEPT which of the following statements is inaccurate?

a. Types and approaches: Even if it is difficult to estimate their likelihood, REVERSE stress tests that "break the bank" deserve consideration
b. Types and approaches: Scenarios should not be too severe, as severity may stretch credibility with shareholders. If the scenario challenges the institution's viability, then it is probably too severe
c. Capital and liquidity: Stress testing for capital/liquidity adequacy should be coordinated with annual planning cycles and should be refreshed in the event of a major strategic decision
d. Coverage: Good stress testing coverage includes (i) inclusion of portfolios, exposures, liabilities and business-line activities; (ii) various LEVELS of the organization; (iii) interplay between exposures; and (iv) various time horizons

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