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P1.T1.20.13 Enterprise Risk Management (ERM): scenario analysis and behavioral concepts

Nicole Seaman

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Learning objectives: Describe important dimensions of an ERM program and relate ERM to strategic planning. Explain the role of scenario analysis in the implementation of an ERM program and describe its advantages and disadvantages. Explain the use of scenario analysis in stress testing programs and in capital planning.


20.13.1. Scenario analysis is an ascendant tool. After the global financial crisis (GFC), regulators insisted that systemically important banks demonstrate their ability to withstand adverse and severely adverse scenarios. Meanwhile, GARP explains, "Scenario analysis, along with stress and sensitivity testing, have risen to become the preeminent risk identification tools for many enterprise risk management (ERM) programs. This is a result of the weaknesses in probabilistic risk metrics (e.g., VaR) that were revealed by the global financial crisis of 2007–2008."

Which of the following statements is TRUE about scenario analysis?

a. An advantage of scenario analysis is that data science enables the bank to generate a virtually infinite number of scenarios
b. Scenario analysis involves changing one parameter or variable in a risk model to see how sensitive the model result is to the analysis
c. A disadvantage of scenario analysis is its necessary dependence on referencing actual historical events such as the global financial crisis (GFC)
d. An advantage of scenario analysis is that it does not need to consider risk frequency beyond plausibility; ie., scenario analysis may be entirely qualitative

20.13.2. As part of the Dodd-Frank Act, as of 2011, the Federal Reserve began conducting two separate annual stress test exercises: Dodd-Frank Act stress tests (DFAST), which are conducted in the middle of the year for all banks with assets above USD 10 billion; and Comprehensive Capital Analysis and Reviews (CCAR), which are conducted at the end of the year for banks with assets above USD 50 billion. In regard to the CCAR, each of the following statements is true EXCEPT which is false?

a. Scenarios should include the interactions and dynamic (ie, not static) behavior of multiple risk factors
b. Banks must project how their macroeconomic scenarios drive income statements and balance sheets over a horizon of nine quarters
c. Banks must include the effects of groupthink (by their employees) and herding (by their major customers) in macroeconomic loss aversion scenarios that might force liquidity crunches
d. Banks must submit detailed capital plans that include sources and uses of capital over the planning horizon and expected business plan changes likely to impact capital adequacy/liquidity

20.13.3. Alice, Bert, Chris, Don, Eva, and Fred are individual investors. Each of them exhibits a particular behavioral bias.
  • Alice (A) invested in the stock Cloudera (CLDR) and bad news (aka, new information) renders her original thesis obsolete but she is reluctant to sell today because an exit implies the realization of a -30.0% loss on the position and she much prefers to sell after her position experiences a double-digit gain
  • Bert (B) can buy a new smartphone for $79.00 but he cannot resist a sale and prefers to pay $100.00 because it represents a 50.0% discount from the retail (MSRP) price
  • Chris (C) attends an investment conference but he avoids the seminar focusing on recession risks because he is overweight homebuilders and he worries the topic will make him anxious with worry
  • Don (D), who enjoys food shopping, tends to be price-conscious (eg., he seeks bargains) when he pays cash at Sprouts or Trader Joes, but when he uses his Amazon credit card at Whole Foods he doesn't worry about the cost because he doesn't look at the statement for several days or weeks
  • Eva (E) purchased Facebook (FB) at $160.00 because his firm's price target was $200.00 and he decides to ignore new information until the price reaches this level
  • Fred (F) was previously a patient buy-and-hold investor who purchased high-conviction stocks and only checked his portfolio once a week, but last year he signed up for a subscription to Seeking Alpha and since that time his buy/sell transactions have quintupled because he's reading news about his portfolio holdings every day
Which of the following correctly matches the individual investor to his or her behavioral bias?

a. A = Home bias, B = Mental accounting, C = Ostrich effect, D = Herding, E = Groupthink, F = Framing
b. A = Loss aversion, B = Framing, C = Ostrich effect, D = Mental accounting, E = Anchoring, F = Feedback effects
c. A = Groupthink, B = Herding, C = Home bias, D = Framing, E = Loss aversion, F = Ostrich effect
d. A = Mental accounting, B = Home bias, C = Loss aversion, D = Groupthink, E = Feedback effects, F = Herding

Answers here: