Scenario analysis (SA) is one of the four pillars of the advanced measurement approach (AMA) for operational risk to calculate regulatory capital. It is also a pillar of good risk management, as well as internal capital assessment, regardless of whether the institution performs capital modeling for operational risk. Scenario analysis is accurately defined as “the assessment and management of the exposure to high severity, low frequency events on the firm.” It includes management as well as measurement. It focuses on the extremes and is not limited to financial impact.
Scenario analysis identification and assessment is a natural extension of the risk identification exercise. In fact, most of the top‐down risk identification tools presented in the previous chapter can be used for scenario identification as well. This chapter focuses on the first two steps of the scenario analysis process. The different methods for scenario assessment and quantification are covered in Chapter 7.
Scenario analysis typically includes the following steps:
- Preparation and governance.
- Generation and selection.
- Incorporation into management.
- Scenario aggregation.
- Incorporation into capital.
SCENARIO PREPARATION AND GOVERNANCE
One of the main challenges in scenario analysis is the consistency of approach and the mitigation of behavioral biases. It is, however, a strong regulatory requirement that scenario analysis should lead to repeatable ...