Introduction to Scenarios and when to use them
Our next series of blogs are all about scenarios. How and when they are used, how they compare to credit risks, how to develop practical scenarios and how to manage them using operational risk software.
Taken from: Mastering Risk Management
Scenario analysis is an essential tool for a firm’s planning and risk management processes. It is rooted in the firm’s business and strategic objectives and should form part of the process of identifying those objectives through challenging them. Scenarios alert the firm’s management to adverse unexpected outcomes, beyond those which have been identified in risk and control self-assessments or modelling, and supplement other risk management approaches and measures. Scenarios are not forecasts of what is likely to happen; they are deliberately designed to provide exceptional, but plausible, possible outcomes. They are necessarily forward-looking and therefore involve an element of judgement. Finally they are invaluable during periods of expansion, by providing a useful basis for decisions when none is available from other sources.
Stress testing and scenario analysis interact with the three fundamental processes of risk, and are also a natural part of modelling.
Why use scenarios?
Scenarios are particularly important in risk management because the only other forward-looking, albeit subjective, information is available from risk and control self-assessments. Scenarios usefully supplement and provide challenge to the equally subjective risk and control self-assessments. By having two sets of data challenging each other, both of which have been derived subjectively, better clarity is achieved and a firmer base is available from which to create action plans to enhance risk management, perhaps through improving controls or implementing further controls. Trends in key risk indicators may also be forward-looking, based on actual current and past data. As such, the trends form a useful input when creating scenarios.
Scenarios also help overcome some of the limitations of models and other historic data. All models, including risk models, are constructed on the basis of a number of assumptions, such as correlations. These assumptions are often lost in the mists of time or enthusiasm, are forgotten or are simply ignored. For instance, IT systems failure may be correlated with the business continuity plan. However, if the IT system does break down, it may turn out that there is no need to invoke the business continuity plan. The correlation is not as certain as had been thought. Challenging the models through extreme but plausible scenarios tends to uncover where some of these assumptions break down when an extreme event occurs. In addition, there is often a lack of appropriate loss data in risk management. Constructing hypothetical yet realistic additional data points can shed useful light on rare events.
By giving transparency to management thinking about the firm’s exposure to risk, scenarios support both internal and external communication. They can enable staff to understand more fully the board’s and senior management’s approach to risk. And if they are reported in the annual report and accounts, they can assist investors to monitor their investment and to hold the board accountable. They can also demonstrate the quality of the firm’s risk management.
Scenarios, of course, also feed into capital and liquidity planning. They provide a useful stretch and challenge to the assumptions underlying the firm’s financial planning and enable the board and senior management to understand better the sensitivities of the firm to its risk exposures. Similarly, indicator thresholds and risk appetite gaps are exposed, so that management can better identify where additional controls may be necessary or where a higher risk appetite may be appropriate.
Finally, contingency planning, risk appetite and strategic planning are all supported by scenarios through the challenge which they provide. Contingency planning is quite naturally about exceptional events, although only a few limited events are usually contemplated. Scenarios enable a wider variety of situations to be considered for which contingency planning may be a valuable and practical solution. Risk appetite too is assisted by the use of scenarios in that a firm can better understand the limits of its risk appetite and how far beyond those limits exceptional but plausible events take the firm.
Despite all the above points, scenarios should not be considered as the salvation to all risk management weaknesses and problems. They are an important tool in the risk manager’s tool kit, but only one among many.
Next Tony and John explain the different between scenarios, stress testing and credit risks.
Mastering Risk Management by Tony Blunden and John Thirlwell is published by FT International. Order your copy here: https://www.pearson.com/en-gb/subject-catalog/p/mastering-risk-management/P200000003761/9781292331317
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