Chapter 3 listed the seven steps of a scenario analysis process, from preparation to incorporation into capital, and focused on the first two. This chapter reviews the next three steps: assessment, validation and management lessons. The final two steps – aggregation and incorporation into capital – will be covered in the next chapter.
Scenario assessment is probably the most challenging task in the scenario analysis process. Assessing likelihood is tricky, if not illusory in some instances. Assessing severity needs the rigorous inclusion of business data to avoid exaggerations and distortions affecting the process. Scenario assessment requires a structured and reasoned approach, rooted in the business reality. This chapter reviews different methods financial companies use to assess the likelihood of rare and extreme events impacting their businesses. These methods will be presented from the least sophisticated to the more sophisticated, after presenting the principles of severity and frequency assessment.
The severity assessment of each scenario is the evaluation of the total negative impacts, direct and indirect, financial and non‐financial, that the scenario would generate. Non‐financial impacts, such as interruption of service, regulatory scrutiny or customer detriment, need to be assessed and converted in financial terms, to ensure a comprehensive assessment of the scenario severity. Direct losses may include money loss, ...