Scenario Analysis
Contents
Definition
Scenario Analysis is a set of practices and tools that be used in the context of Risk Management to produce a forward-looking view of the risk (and opportunities) facing an organization. Scenario analysis is a process for identifying and assessing a potential range of outcomes of future events under conditions of uncertainty. A process of analyzing future events by considering alternative possible outcomes.
Scenario analysis is a tool to enhance critical strategic thinking. A key feature of scenarios is that they should challenge conventional wisdom about the future. In a world of uncertainty, scenarios are intended to explore alternatives that may significantly alter the basis for “business-as-usual” assumptions.[1]
Usage in Credit Risk
In the context of Credit Risk, scenario analysis forms the basis of Stress Testing. For example in the context of assessing Revenue Risk.
Usage in Operational Risk
In the context of managing operational risk regulated banks must use scenario analysis of expert opinion in conjunction with external data to evaluate exposures to high-severity events.[2]. Some design elements
- The approach should draw on the knowledge of experienced business managers and risk management experts to derive reasoned assessments of plausible severe losses.
- These expert assessments could be expressed as parameters of an assumed statistical loss distribution.
- In addition, scenario analysis should be used to assess the impact of deviations from the correlation assumptions embedded in the bank’s operational risk measurement framework, in particular, to evaluate potential losses arising from multiple simultaneous operational risk loss events.
- Over time, such assessments need to be validated and re-assessed through comparison to actual loss experience to ensure their reasonableness
Usage in Climate-Related Risk
Financial institutions also conduct Climate Change Scenario Analysis to test the resiliency of their portfolios against a range of issues, including climate change. For example, pension funds and asset managers have conducted scenario analyses of their investment risk. Banks also recently assessed the impact of environmental factors on the credit risk of its loans using a stress testing approach, a form of scenario analysis.
