Fanto, James --- "Stress Testing and Scenario Analysis in Risk Management: Preparing for the Worst" [2010] ELECD 692; in Mitchell, E. Lawrence; Wilmarth, Jr, E. Arthur (eds), "The Panic of 2008" (Edward Elgar Publishing, 2010)

Book Title: The Panic of 2008

Editor(s): Mitchell, E. Lawrence; Wilmarth, Jr, E. Arthur

Publisher: Edward Elgar Publishing

ISBN (hard cover): 9781849802611

Section: Chapter 3

Section Title: Stress Testing and Scenario Analysis in Risk Management: Preparing for the Worst

Author(s): Fanto, James

Number of pages: 17

Extract:

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 busi-
ness 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 ...