Causes, Consequences and Implications for Reform
Edited by Lawrence E. Mitchell and Arthur E. Wilmarth, Jr
Chapter 3: Stress Testing and Scenario Analysis in Risk Management: Preparing for the Worst
James Fanto1 INTRODUCTION The purpose of this chapter is to consider how several risk management practices, including stress testing and scenario analysis, contributed to the problems in the large financial institutions that were at the heart of the current financial crisis. The goals of risk management are to assess the risks facing a financial institution as a result of its activities and the business environment, to monitor the risks for any change, to determine whether the institution has the resources to deal with the risks, to alert senior managers and boards of directors about the risk information and to suggest courses of action for the decision makers to take to address the risks. During the past two decades, the risk management process has become increasingly dominated by the use of quantitative risk models that, for a given financial asset or class of assets, predict the probability and amount of loss for a future period at a given confidence level. However, risk management also includes stress testing and scenario analysis, which, in general, involve testing an institution against possible adverse future situations and predicting the institutional consequences of them. My argument is that stress testing and scenario analysis in systemically important financial institutions failed, which contributed to the collapse of many large financial institutions and the meltdown of the financial system. There are a number of reasons for this failure, both those internal and external to these risk management practices. The chapter identifies the reasons and offers suggestions on how stress...
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