After studying this chapter, you should be able to:
1 Understand the basic approaches to scenario analysis and stress testing and the pros and cons of these two approaches
2 Outline the benefits of operational risk models and the differences between top-down and bottom-up approaches
3 Explain the more common top-down models such as stock factor, income-based, expense-based, operating leverage, and risk profiling models
4 Explain the more common bottom-up models such as asset and liability management, market factor, causal, and operational variance models.
The previous chapters outlined the process of operational risk management, from the early stages of identifying and categorising risk, through the process of developing an operational risk management framework, measuring risk, limiting it, and reporting it. Here we delve deeper into the process of analysing risk, outlining in deeper fashion a series of tools and operational risk models.
Scenario analysis is particularly useful to understand the impact of operational and business events by creating scenarios and taking them to their conclusions. Effective scenario analysis considers the likely, the probable, and the improbable. Because it is very subjective, scenario analysis is also very flexible, and there is its strength.
Stress testing is another useful tool to consider the impact of events. In typical stress testing, key risk factors like price, volume, resources, ...