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

By Ryan, Jim; Shu, David | The RMA Journal, April 2009 | Go to article overview

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


Ryan, Jim, Shu, David, The RMA Journal


[ILLUSTRATION OMITTED]

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. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

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

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.