Chapter 8: Operational Risk Tools - Scenario Analysis Flashcards
**nature and role of scenario analysis **
What is the role and composition of a scenario in operational risk management?
- a scenario is an outline or model of a combination of unexpected or adverse events that are ‘severe but plausible’ (likely to happen).
- Scenarios, typically described using event types or risk categories, detail the causes and potential impacts of the event.
- They are used in scenario analysis exercises to assess a firm’s exposure over time.
- A scenario includes a description of the event, an inventory of relevant risks and controls, relevant loss data, risk indicators, and a causal analysis.
- Scenarios can be maintained in a library or repository and adapted to reflect changing circumstances.
- They are also used for risk capital calculation purposes.
Examine the nature of scenarios
What is the purpose of a scenario in risk management?
- A scenario in risk management is a story or model of a possible sequence of unexpected or adverse events, such as a cyber-attack or a pandemic. Firms and individuals examine these scenarios to assess their exposure should such events actually occur. Therefore, scenarios are considered a powerful forward-looking tool for managing risks.
What are some of the key objectives for conducting scenario analysis in risk management?
- Obtaining consensus on the firm’s exposure to severe but plausible risks,
- Identifying specific exposures where the firm is inadequately prepared,
- Evaluating medium and long-term exposures for capital estimation or loss provisioning
- Understanding risks and exposures related to new business activities,
- Complying with regulatory requirements in evaluating particular exposures.
Types of scenarios
What are the challenges in creating multi-variable scenarios in risk management?
- Challenging due to the need to establish boundaries.
- The more variables a scenario has, the more likely the output will be unrealistic and hard to reproduce consistently.
- Different assessors may place different emphasis on individual components of the scenario, leading to diverging opinions on the implications for the firm.
What is the difference between bottom-up and top-down scenarios?
- Bottom-up scenarios are driven by the business based on actual exposures and are valuable for assessing exposure, measuring the firm’s response to the scenario, and identifying potential gaps in the control environment.
- Top-down scenarios, determined at a senior management or governing body level, are used in response to regulatory directives, industry events, strategic planning, or capital estimation processes.
How do the types of business or products offered by a firm influence the scenarios used in risk management?
- For example, global markets businesses might use a rogue trading scenario.
- Asset management might use a serious fiduciary breach scenario.
- Retail banking might use a coordinated cyber-attack scenario.
- Some generic scenarios, like key people leaving the firm or core system outages, can be assessed across the entire firm.
Describe the benefits of scenario analysis
While the use of scenarios is a required component of capital estimation under the AMA approach to operational risk capital estimation, firms utilize scenario analysis for various purposes beyond just capital estimation.
* Helps embed a strong risk culture in the business and the firm’s governing body.
* Helps identify new strategic and operational challenges emerging in the business environment and provides forward-looking assessments of these risks.
* Informs the setting of the firm’s risk appetite and tolerance for losses.
* Identifies where the firm may require specific forms of insurance, providing a mechanism for fair valuing any insurance considered and supporting existing insurance renewals; and
* Supports training outcomes, in that staff can be exposed to, and prepare for, potential adverse issues and situations they may face, even if the scenario is more extreme than most people’s experience to date.
* Identifies and supports the development of controls and risk mitigation strategies, business and contingency planning, and internal and external reporting procedures.
* Feeds into enterprise-wide capital planning, measurement and allocation, and helps fulfil other regulatory requirements.
Describe the internal and external factors that can influence the scenario analysis process?
Internal Factors:
Purpose of Scenario Analysis: The process, content, approach, participation, and output of the scenario analysis are influenced by its purpose. A clear upfront purpose ensures efficient and useful analysis.
**Participant Selection: **The selection of participants with the right level of knowledge and experience is crucial. Participants should ideally have broad business experience and specific knowledge relevant to the scenario being considered.
**Variety of Functions: **Participants from a variety of functions provide different perspectives on the scenario, enriching the analysis.
External Factors:
**Business Environment: **The firm’s and the broader business environment can influence scenario analysis outcomes. Factors such as a recession, inflation, or cost-cutting programs can affect participants’ judgments.
Changing Environment: The business environment changes over time, and this can lead to different responses to the same scenario, affecting the consistency of scenario output. Regular reviews of scenarios are recommended to account for these changes.
Business Environment Factor Assessment: Some firms conduct a business environment factor assessment before the scenario analysis to ensure all participants have the same reference point. This involves collating collective views on the business environment and assumptions into a document.
In summary, both internal factors (like the purpose of the analysis and participant selection) and external factors (like the business environment and its changes) play significant roles in influencing the scenario analysis process.
What factors should be considered when deciding on an approach for scenario analysis, and how do these factors influence the choice of approach?
The choice of approach for scenario analysis is influenced by two main factors:
* The purpose of the analysis and the level and availability of the participants.
* The purpose of the analysis could range from establishing exposure to a scenario, determining the firm’s likely response, to identifying control gaps.
* Depending on the purpose, different approaches like war gaming, workshops, interviews, Delphi methods, or online questionnaires might be suitable.
* The level and availability of participants also play a role. For instance, senior participants with limited availability might prefer online questionnaires or short interviews, while workshops might be more suitable for junior staff or large groups.
*The approach should also aim to minimize the risk of bias and undue influence from a small number of individuals.
What are the various approaches firms use for scenario analysis and how do they design their programmes?
Firms use a variety of approaches for scenario analysis and design their programmes iteratively. They might use interviews or online questionnaires in the first round to gather individual perspectives, workshops in the second round to confirm and finalise results, and possibly war gaming in the third round to develop corrective activities.
Each approach has its own strengths and weaknesses:
Workshops are common and involve a range of participants discussing the scenario under the guidance of a facilitator. However, they can be biased and may not work equally well in all regions due to cultural differences.
Interviews require strong facilitation skills and are effective in countering bias. They are suitable for senior participants but are resource-intensive.
Online questionnaires allow participants to complete their assessments at their convenience but require participant discipline. The facilitator has no control over participant action outside of the tool.
The Delphi method uses a panel of experts who answer questions about a given scenario in two or more rounds. It seeks convergence of expert opinion but can lead to diverging opinions.
Research and verification involves a central team conducting research into the scenario and presenting participants with historical data. Participants are asked to verify that the results represent an extreme but plausible outcome for the scenario.
External data minimises the time impact on participants. An analyst researches external loss data to obtain a severe but plausible impact for the area of concern. The results are then used as the basis for analysing the firm’s exposure internally.
War games anticipate competitive developments and formulate viable options in response to the emerging scenario. Participants work in teams against each other and establish strategies to defend their position. War games are time- and resource-intensive, and more suited to ad hoc analysis. They do not readily support consistent reassessment of a scenario over time.
What are the key challenges that a scenario analysis programme needs to address and overcome?
Getting the right people involved: This includes finding good facilitators who have business knowledge and skills, good interpersonal skills suitable for facilitating workshops and interviews, and the ability to manage bias and gaming.
Encouraging participants to ‘think the unthinkable’: Participants may feel uncomfortable responding to a particular scenario and may need guidance to express an opinion without introducing bias or being led to an answer.
Maintaining plausibility of scenarios: While creativity from participants is encouraged, it sometimes requires management by the facilitator to ensure an appropriate balance between extreme but plausible outcomes is obtained.
Ensuring common understanding among participants: Language, culture, and terminology all play a role in shaping a participant’s understanding of what they are being asked to evaluate and respond to. Without a common understanding, the response data will not be comparable.
Converting subjective measures into objective data parameters for capital modelling estimates: This includes applying filters to exclude complete outliers(removing the most unusual cases to get a clearer picture of the common trend or pattern). A way to address this challenge is to design the data to be collected during the scenario analysis process specifically so they can be usable for modelling purposes.
Obtaining regulatory acceptance: Particularly if the scenario assessment output is to be used in capital estimation. This will require the firm satisfying its regulator that these challenges, particularly the ones related to completeness, consistency, bias and gaming, have been adequately addressed.
Budgeting: A comprehensive, well-organised scenario analysis programme will require a reasonable financial budget, not just for the staff who manage the programme, develop the scenarios and facilitate the assessment sessions, but also in terms of time investment by management and participants.
Identifying the areas to be covered by the scenario
What are the common approaches to scenario identification in the scenario analysis process and how does the purpose of the analysis influence this process?
The purpose of scenario analysis influences the approach to scenario identification. If the goal is to fill data gaps for capital estimation, the focus is on these gaps. If the aim is to identify unprepared exposures, the process uncovers ‘unknown unknowns’.
Common approaches include:
**Loss event driven approach: **Assesses historical losses to select exposures to assess.
Risk-driven approach: Focuses on identified risks using the firm’s Risk Control Self-Assessment (RCSA) programme.
Control-driven approach: Concentrates on key controls and the impact of their failure.
Expert opinion: Relies on experts’ suggestions but can introduce bias and is limited by the expert’s knowledge.
Industry standards: Considers specific scenario sets selected by industry groups but doesn’t account for firm-specific exposures.
Regulatory requirements: Follows scenarios imposed or advocated by regulators.
Research: Staff research emerging themes, top risks, regulatory focus areas, and other sources to identify areas of concern.
Constructing the scenario
What information should be included in the documentation of a new scenario for scenario analysis?
For scenario analysis, the documentation of a new scenario should include:
- A clear name and detailed description of the scenario.
- The time horizon for the scenario’s manifestation.
- Scope of the scenario, including what is included and excluded.
- Direct and indirect impacts of the scenario.
- Causal factors for the scenario’s occurrence.
To enrich the scenario description, include:
- Existing controls.
- Risk or control indicators for early warning.
- Relevant business environment factors.
- Relevant historical loss data.
- Previous scenario analysis results.
Outputs from the scenario analysis
What are the key outputs required from participants in the scenario analysis process and how do these vary based on the intended use of the scenario?
In scenario analysis, key outputs include:
Frequency: The number of times the scenario may occur within a set time frame.
**Likelihood: **The chance of the scenario happening, often categorized as low, medium, or high. It’s crucial to distinguish between likelihood and probability, the latter being a quantitatively calculated chance.
**Impact and severity: **These interchangeable terms refer to the potential direct or indirect, financial or non-financial effects of the scenario. Impacts, especially for capital estimation, are usually converted to a specific currency amount and can range from ‘worst case’ to ‘extreme case’ scenarios.
The collected information varies based on the scenario’s purpose. For instance, if the scenario is for assessing a firm’s capital requirement, all necessary data for the capital model should be collected. Involving other stakeholders who will use the output can help ensure their needs are met.
Bias and gaming
What are the common concerns and biases in scenario analysis, and how can they be addressed to ensure a robust scenario analysis programme?
In scenario analysis, concerns include its subjectivity and reliance on ‘expert opinion’, leading to potential bias and misrepresentation of exposures.
To mitigate these, a robust programme should have clear documentation and use varied tools like interviews for capital measurement scenarios and workshops for operational management scenarios.
Three relevant biases are:
Subconscious or judgmental bias: Stemming from participants’ information, frame of reference, processing ability, memory limitations, anchoring, and tunnel vision.
Extraneous bias: Resulting from the facilitation of scenario assessment, information order, facilitator’s attitude and body language, interruptions, and the firm’s risk culture.
Conscious or motivational bias: Arising from interested risk or control managers, ‘herd instinct’, ‘lead bull’, deliberate gaming, perceived link between scenario impact and capital estimation, and truth concealment.
By recognizing and addressing these biases, a scenario analysis programme can yield more accurate and useful results.
