19 January 2006

Scenario Analysis: The Value of the Hypothesis...

In the December 2005 issue of OpRisk and Compliance Magazine Dean Lamble from Hewlett-Packard has this to say in the article on "Planning for Disaster":

Key areas will include security, evolving threats of terrorism, and how to cope with a pandemic outbreak such as bird flu. Companies will be paying far more attention to how the contingency plans perform when tested. Compliance continues to be a key concern, with increasing legislation directing responsibility to the board.

More than 25,000 banks around the world will work to comply with Basel II over the next five years. One of its most controversial aspects is the inclusion of Operational Risk Management. While banks have attempted to manage operational risks for many years, now for the first time they must measure it.

Most money center banks have already achieved high levels of competency with capturing loss events and with risk self-assessments. Scenario analysis and KRI (Key Risk Indicators) is still a distant goal. OPS Risk is still a maturing discipline and regulators are allowing some flexibility here. However, financial institutions are still stuck to some degree on imagining incidents that have not occured to them in the past. Probabilities are not low just because they haven't happen to your institution historically.

A hypothesis is the place to begin.

hy·poth·e·sis ( P ) Pronunciation Key (h-pth-ss) n. pl. hy·poth·e·ses (-sz)

1. A tentative explanation for an observation, phenomenon, or scientific problem that can be tested by further investigation.

2. Something taken to be true for the purpose of argument or investigation; an assumption.

3. The antecedent of a conditional statement.

If an event has happened to another insitution is it so improbable that it could also happen to your own firm? The starting point for effective scenario analysis is the intelligence and the external data that provides the evidence of such an incident. Then the goal is to gain "insight" on how it could happen and what the impact would be in your own environment. Capture of data on extreme events is imperative even if only one $10M. event has occured in the last ten years.

Today, an audio tape from Osama bin Laden has been posted on the Internet along with a transcript of his comments. The authenticity is being validated as he has not been heard from for over one year. Has your scenario analysis included potential events of the magnitude of the 7/7 bombings in London or the 11/9 Amman Jordan suicide attacks on three Western hotels?

"Bruce Newsome, a terrorism researcher at the think tank RAND, said the plot carried out by four men in London is a "likely model for future U.S. attacks." The bombers, all British citizens, had no criminal records, weren't on any watch lists and had no extremist pasts. (A fifth man, believed to be the mastermind of the plot, has been arrested in Egypt.) Tracking such potential perpetrators is nearly impossible because there are no warning signs, Newsome said."

Somewhere in your contingency planning and scenario analysis there must be hypothetical loss events on the magnitude beyond our imagination.

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