LESSON 10: STRESS TESTS AND SCENARIOS

Video Activity Text Additional reading and references

10.1 PURPOSE

Review stress testing and scenario analysis as essential tools for a firm’s planning and operational risk management processes.

10.2 KEY CONCEPTS

Targets Thresholds Key risk indicators

Periodicity Leading indicators Key performance indicators
Action plans Lagging indicators Key control indicators
Dashboards Validation Risk and control assessment

10.3 LEARNING OUTCOMES

On completion of this lesson, you should be able to

 differentiate between stress testing and scenario analysis

 explain the use of scenarios
 discuss the problems with scenarios
 discuss the solutions to improve on scenario analysis
 discuss the points to consider before developing scenarios
 explain how to develop a set of practical scenarios
 explain how to prepare for an extreme event
 discuss the typical problems that follow scenario development
 discuss the actions related to worst-case scenarios
 apply scenarios to operational risk management data

10.4 LEARNING MATERIAL

Chapter 10 of the prescribed book: Stress tests and scenarios.

10.4.1 Introduction

Stress testing and scenario analysis are essential tools for operational risk management processes and are rooted in business
and strategic objectives. Stress tests and scenarios alert management to unexpected adverse outcomes apart from those
identified in risk and control assessments or modelling. Stress tests and scenarios are forward-looking and require judgement,
providing severe and plausible possible outcomes.

Study “Introduction” in chapter 10.

10.4.2 What are they and what is the difference between them?

Stress testing and scenario analysis are the identification and analysis of the potential vulnerability of a firm to exceptional
but plausible events. Stress testing is a particular case of scenario analysis in which a single parameter changes. By contrast,
scenario analysis is about simultaneously changing multiple parameters by a predetermined amount, based on statistical
results, expert knowledge or historical events.

Study “What are they and what is the difference between them?” in chapter 10.

10.4.3 Why use scenarios?

Scenarios are used to

 supplement and challenge risk and control assessments

 help overcome some of the limitations of models and historical data
 challenge some of the assumptions models are based on
 support both internal and external communication
 challenge the assumptions underlying financial planning
 expose gaps in indicator thresholds and risk appetite
 support contingency planning

Study “Why use scenarios?” in chapter 10.

10.4.4 Problems with scenarios

 Scenarios are often related to relatively regular events and based on time frames that are too short.
 Scenarios often do not produce sufficiently large enough loss numbers.
 Scenarios are often performed as an isolated exercise and are not linked to business objectives.
 Scenarios are often conducted as mechanical and point-in-time exercises that do not account for reaction to
unfolding events or changing business conditions and do not incorporate qualitative judgements.
 Scenarios are often based on the assumption that very little change is required to the details of historical events in
order to forecast future risks.
 Scenarios often ignore reputation risk.

Study “Problems with scenarios” in chapter 10.

10.4.5 How to improve on scenarios

 Scenarios should be reviewed so that they can be adapted to changing market and economic conditions, as well as
the changing risk profile of the firm.

 Scenarios should be reviewed or developed when new products are launched to identify potential risks and to
incorporate the new products within the scenarios.

 Risks which correlate should be identified, and the aggregation of these risks should be considered.

 Correlations between risks should not be underestimated, and emerging correlations should be considered.

 Consider the feedback effects across industries or markets and appropriate time horizons.
Study “How to improve on scenarios” in chapter 10.

10.4.6 Governance

Good governance will enable the board and senior management to guide and direct the operational risk scenario strategy and
to review its effectiveness by

 setting the scenario objectives

 defining the scenarios
 discussing and promoting the discussion of the results of the scenarios
 assessing potential actions and making clear decisions based on the results
 fostering internal debate on the results of the stress tests and scenarios programme as a whole
 challenging prior assumptions such as cost, risk and speed of raising new capital or hedging/selling positions

Operational risk scenarios should enable a firm to understand the sensitivities of all of the elements of the firm’s operational
risk exposure, as set out in the operational risk framework. This includes

 clarifying interactions and causal relationships between the risks and controls

 acting as a challenge to the subjective nature of risk and control assessments

 compensating for the lack of internal loss data

 allowing adjustments to the likelihood and impact assumptions in risk assessments

 allowing adjustments to the design and performance assumptions in control assessments

Study “Governance” in chapter 10.

10.4.7 Points to consider before developing scenarios

 the crisis management team

 combinations of events over some time
 recognising and mitigating natural biases
 assumptions
 environment
 historical or hypothetical data

Study “Points to consider before developing scenarios” in chapter 10.

10.4.8 Developing a set of practical scenarios

This involves
 using risk and control assessments
 random words
 using industry information
 using news stories
 common scenario outcomes
Study “Developing a set of practical scenarios” in chapter 10.

10.4.9 Preparing for the extreme event

A firm can prepare itself by adopting a variety of defensive approaches once common themes have been identified. Scenarios
test risk assessments and risk appetite, and it is essential that the defensive approaches also be tested. These defensive
approaches should be in place and used during regular times so that they are part of the usual way of doing business. The
following represent defensive approaches:
 a strong risk culture
 an integrated risk management approach
 informed decision-making
 knowing and understanding risk appetite
 continuous business process improvement

Study “Preparing for the extreme event” in chapter 10.

10.4.10 Typical problems following scenario development

 balancing effort and understanding

 rejection of the technique
 paralysis

Study “Typical problems following scenario development” in chapter 10.

10.4.11 The near-death experience (i.e. worst-case scenario)

Actions related to scenarios most likely to cause the failure of a firm are
 reverse stress tests
 recovery plans
 governance
 triggers
 communication plan
 resolution plan

Study “The near-death experience” in chapter 10.

10.4.12 Applying scenarios to operational risk management data

There are two main approaches to applying scenarios to operational risk management data:
 A deterministic approach uses a simple and straightforward approach, although it is sometimes difficult to relate to
reality. It is far less rigorous and relies on assumptions to a much greater extent.
 A probabilistic approach uses a statistical methodology for modelling risks and controls, although it is sometimes
challenging to understand due to the underlying complex mathematics.

Study “Applying scenarios to operational risk management data” in chapter 10.

10.5 SUMMARY
Scenarios are all about the unimaginable and the unthinkable. They are practical exercises aimed at identifying events or
combinations of events which could threaten a firm’s objectives and even its existence. Scenarios bind all the elements of the
framework together and test whether the operational risk framework is robust and fit for its purpose.

Study “Summary” in chapter 10.

10.6 ACTIVITY

Self-assessment questions: Go to the Online assessment tool to do activity 10.5.

10.7 REFLECTION

Before you continue to the next lesson, reflect on the following personal questions:

a. Where, in your professional life, do you think you will be able to use the skills you have learnt in
this lesson?
b. What did you find difficult? Why do you think you found it difficult? Do you understand it now, or
do you need more help? What are you going to do about it?
c. What did you find interesting in this lesson? Why?
d. How long did it take you to work through chapter 10 for this lesson? Are you still on schedule, or
do you need to adjust your study programme?
e. How do you feel now?

Blunden, T & Thirlwell, J. 2013. Mastering operational risk: a practical guide to understanding operational risk and how to
manage it. 2nd ed. London: Pearson.