The $700 Billion Scenario: A Fresh Look at Scenario Analysis in Strategic Risk Management

Article excerpt

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REMEMBER SEPTEMBER 2008?

September 7. The Federal Reserve takes over Fannie Mae and Freddie Mac.

September 14. Bank of America purchases Merrill Lynch.

September 15. Lehman Brothers files for bankruptcy.

September 17. The U.S. government rescues AIG with an emergency loan of $85 billion.

September 18. Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson hold an urgent and unusual session on Capitol Hill in which Paulson tells stunned congressional leaders: "We're literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally." (1)

September 21. Treasury Secretary Paulson proposes a $700 billion financial bailout package. (2)

What is shocking is not just the cost of the rescue program (some estimates put the global cost of the crisis at $8.5 trillion (3)),but how underprepared financial institutions and the federal government were for an extreme risk event. One senator on the Banking Committee compared the rescue plan to "flying a $700 billion plane by the seat of our pants." Another senator added, "Shouldn't we have the process designed before we have to do a $700 billion experiment?" (4) The markets declined with unprecedented volatility as investors became even more anxious about the uncertainty (i.e., risk) that lay ahead. An avoidable situation that unfolded over more than 10 years became a nightmare scenario in a matter of days.

Lessons Learned

While these events may be extreme, they are neither extremely rare nor impossible to prepare for. In fact, negative events related to the financial crisis predate 1996, when Alan Greenspan made his famous remark about "irrational exuberance" in relation to unduly escalated asset values. (5) Subsequent events in the aftermath of Greenspan's remarks continued to occur despite efforts by regulators to increase controls and spotlight critical weaknesses in the management of credit, market, and operational risks.

Many financial models were built upon unrealistic premises. In 1999, Benoit Mandelbrot, a renowned mathematician, warned in his article "How Fractals Can Explain What's Wrong with Wall Street" that the classical financial models suggest that extreme events should never happen. Additionally, he stated that the mathematics underlying certain financial models handles extreme situations with benign neglect. He made an analogy of a sailor at sea. If the weather is moderate 95% of the time, can the mariner afford to ignore the possibility of a typhoon? (6) Clearly, managing risks requires both math and critical discussions among experts within institutions. Indeed, it's the only method that has ever worked.

Here's what we learned about these extreme events during the past decade:

* Extreme events always seem "impossible" until they happen.

* Extreme events happen more frequently with increasing magnitude.

* Extreme events come from many sources.

* We tend to extrapolate good times longer than they last.

All financial institutions are affected by extreme events because of interdependencies. When it comes to predicting and coping with extreme events, many firms large and small found themselves in a situation similar to where the federal government was in September 2008. While scenario analysis was becoming a common practice long highlighted by regulators, several firms seemed to fare better during the turmoil. The more fortunate firms appear to have found the balance in their scenarios and stress testing between doomsday and reality. Clearly, firms may not need to hypothesize about the severity of complete dissolution. However, debating and measuring extreme but plausible events that lead to rapid dissolution would be prudent. The difference in scenario development between the strong and the acutely suffering may simply be creativity, defined by dictionary. …