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. The various methods used for scenario analysis are discussed and the important elements of a robust scenario analysis program are explained.
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 the “fat tail” events, or rare catastrophic events. These types of events can put the firm at serious risk. For this reason, scenario analysis is 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 pursing scenario analysis programs as they provide a valuable insight into the major risks faced and also 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. ...