Operational Risk Management, 2nd Edition

CHAPTER 11Scenario Analysis

Scenario analysis is a challenging element in the operational risk framework. Scenario analysis provides the operational risk framework with a tool to explore the rare but plausible losses that could arise as a result of operational risk. In this chapter, we discuss the various methods used for scenario analysis and explain the important elements of a robust scenario analysis program.

ROLE OF SCENARIO ANALYSIS

Scenario analysis has become an important element in operational risk management and measurement, and the methods used have evolved rapidly over the past few years. Firms use scenario analysis to evaluate their exposure to high-severity events. Unlike RCSA analysis, scenario analysis focuses on “fat-tail” events, or rare catastrophic events. These types of events can put the firm at serious risk. For this reason, scenario analysis was a required element in calculating operational risk capital requirements under Basel II for any firm undertaking the Advanced Measurement Approach (AMA).

Firms that do not have AMA requirements are also pursuing scenario analysis programs, as they provide a valuable insight into the major risks faced and provide the opportunity for an engaging dialogue with the business lines.

The role of scenario analysis in the operational risk framework is illustrated in Figure 11.1.

Scenario analysis is used to derive reasoned assessments of plausible severe losses. The assessments are then used to explore “what-if” cases ...