Scenario Analysis - are we missing the point?
Monday, June 1st, 2009Let me start by saying that I believe the importance that regulators are placing on scenario analysis in the light of recent events is a good thing. By identifying key risk scenarios, understanding the underlying risks, stress testing the scenarios and then acting on the results, we will make those scenarios less likely.
My concern is that, by focusing on stress testing of scenarios, rather than scenario analysis itself regulators are at risk of losing a large part of the potential benefit. Worse still, there is evidence that this is leading to the development of lists of standard scenarios, with companies offering scenario libraries to financial services organisations. Surely the whole point of scenario analysis is that it is intended to help to discover (and then understand) alternative future contexts? Rather like Douglas Adams’ philosopher, who demanded “rigidly defined areas of doubt and uncertainty”, the idea of the financial services industry beavering away stress testing standard scenarios while the world changes around us would be laughable if it wasn’t so scary.
In Donald Rumsfeld’s language, stress testing standard scenarios focuses on the known unknowns, and this certainly has value but in the past (including the recent past), it is the unkown unknowns that have risen up to bite us time and again. Financial services organisations need to focus on the process of identifying and defining scenarios that are consequential, challenging and coherent and then understanding how they may arise, so they can devise an early warning system of indicators to help them prevent or prepare for them if they do happen.
Mike MacDonagh
