Scenario Analysis; The What-If? tool

To explore and consider new risks, while calculating operational risk capital, scenario analysis is an essential tool to fulfill such requirement.

Scenario Analysis is one of the most fundamental tools in operational risk management field. According to Basel Committee Scenario analysis is “a process of obtaining expert opinion of business line and risk managers to identify potential operational risk events and assess their potential outcome. Scenario analysis is an effective tool to consider potential sources of significant operational risk and the need for additional risk management controls or mitigation solutions. Given the subjectivity of the scenario process, a robust governance framework is essential to ensure the integrity and consistency of the process.”

Let’s elaborate the importance of Scenario Analysis:

?? The most important benefit of Scenario analysis is to enhance/supplement Internal Loss Database (ILD) with extreme events (i.e. High Severity low frequency incidents) through obtaining expert opinions. Normally, banks do not have many extreme events in their ILDs, therefore it is essential to mitigate such weakness points, to be able to perform the following:

o?? Allocating the sufficient capital.

o?? Developing internal controls through enhancing bank’s systems, policies, procedures, etc..

o?? & Enhancing Business Environment and Internal Control Factor (BEICF) as the developed scenarios can be used while conducting RCSA, while creating inherent risks, & KRIs while monitoring the major risks.

?? Since, the pace of change in the world is?accelerating faster?than we could ever imagine, it also introduces new risks should be mitigating immediately. Scenario analysis will assist to cope with such changes and new risks smoothly.

How to develop Scenario Analysis?

There are the most popular 3 methods of conducting scenario analysis:

?? Structured workshops è to conduct meetings/workshops with the experts.

?? Surveys è to distribute questionnaire/survey to the experts.

?? &/or individualized discussion/interviews è to conduct interviews with experts.

However, it is important to identify the biases of scenario analysis to avoid and/or fix them, while conducting scenario analysis. They can be summarized as follows:

?? Presentation bias: relying on first piece of information heavily while making decision. For example, a cybersecurity incident took place and resulted a loss for USD 500K (1) due to the firewall was not updated (2). When decision makers analyzer the incidents, they may focus on the amount of loss, which is USD 500K, as it was presented first (1) and they may disregard the cause of the loss since it was presented later (2).

?? Availability bias: determining the severity of loss in scenario analysis based on expert’s experience. For instance, an expert in information security field would not estimate a loss of cybersecurity incident more than USD 1 million, since he did not experience similar mega incident – which exceed USD 1 Million – during his/her career.

?? Anchoring bias: determining the range of loss severity based on previous experience or it has been seen elsewhere (i.e. media, etc.). for instance, an expert is trying to figure out the maximum loss, which may incur, if a rouge trade incidents takes place. Since, he/she recently read about such incident in Société Generale bank, he/she may estimate the max. loss would be EUR 4.9 billion (that is identical to SG losses). ?

?? Gaming: since participants/experts may have their own agenda and goals, so they may not disclose enough information, as they may perceive it may contradict with their own best interests.

?? Inexpert opinion: sometimes junior employees attend the workshop instead of head of department.

?? Over/under confidence bias: over/under estimating risks due to the available information/experience.

?? Anxiety bias: the experts tend to avoid differences of opinions and conflicts through depressing their opinions. Therefore, they may fear to disclose full detailed information.

How to solve such issues?

There is a technique to ensure scenario analysis exercise is conducted effectively and to solve the mentioned issues above. The technique is called The Delphi technique. It can be summarized through the following steps:

?? First, while conducting workshop, invite a diversified group of experts together to estimate operational risk incident occurrence. For example, if scenario analysis is about rouge trading incident, then invite dealing room (front office), treasury back office (operations), treasury middle office & for example Asset Liability Management (ALM) experts.

?? Second, ensure all participants are involved in the discussion. Of course, each expert should contribute his/her opinion with additional/marginal information from their experience in their field.

?? Third, Given the information from step 2, the recognized and consolidated description of the issues and their feedback are provided to the group.

?? Fourth, it is optional to highlight the different opinion among participants.

?? Fifth, all information which were discussed and recognized in the workshop should be evaluated and analyzed.