Scenario Analysis in Risk Management
Scenario analysis is the third pillar of the framework suggested by the Bank of International Settlements in their Basel norms. In the previous articles, we have already studied a collection of internal and external loss data as well as the self-assessment of risks. However, it is important to note that the loss data collection framework has certain shortcomings. Firstly, it does not take into account losses that are beyond the mentioned time period. For instance, companies generally maintain loss data for three years. However, if a loss is likely to happen once in ten years, that risk is completely missed out on the loss data framework. Secondly, loss data only considers losses that have actually materialized. Scenario analysis, on the other hand, takes into account losses that may not have occurred till now but which have the potential to occur in the future. This is the main benefit of scenario analysis. They help the company identify emerging risks that are not The methodology used for scenario analysis is much more comprehensive. The internal position of the company is studied in addition to the vulnerabilities posed by the external situation. In this article, we will have a closer look at how scenario analysis works as well as what the shortcomings of this scenario analysis are.
Approaches to Scenario Analysis
There are three approaches that are commonly used by organizations to generate scenarios required for scenario analysis. They have been mentioned below:
The end result of each of these exercises is that the company needs to have a new list of risks that have been identified in the process. The real challenge is the next step wherein these risks have to be converted into numbers. Various statistical techniques are used to do so. For instance, expert opinion is collected about the possible frequency of these losses along with the possible impact. These numbers are then blended in with the empirical distributions and used to generate more detailed data.
Limitations of Scenario Analysis
Although scenario analysis is an excellent tool to identify and mitigate operational risk, it is still based exclusively on the opinion of the experts. If a different set of experts was used to perform the same scenario analysis, the outcome would be significantly different. The effectiveness of the process is completely dependent upon the human beings performing it.
This is the reason why all the cognitive biases play a part in the scenario analysis. For instance, there have been studies which show that if the same experts were presented information in a different order, their opinions were different! The familiarity of the experts with certain types of risks also plays an important part. Experts tend to focus more on risks that they know about and ignore the risks that are new to them. Also, many times experts have a predefined opinion to which they are anchored to. Instead of having an open mind about the new data, they often use the new data points to support their old positions. Many times experts might disagree with one another. However, they will still not voice their disagreement because it would mean confronting others and some people may not want to do that.
The bottom line is that scenario analysis is a very important tool used in the advanced measurement approach suggested by the Bank of International Settlements. Despite its shortcomings, it is the only method that can be reliably used to manage the unknown risks in any organization's operations.
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