Learning from the Past - A Note on Scenario Building

The other day, news broke in Switzerland that the government plans to hold a non-public consultation over the ever-rising Swiss Franc. This sparked a public debate about what the Swiss National Bank could do to stem the tide. While there is no point in me voicing an opinion about what should be done, let’s look what we can learn from this debate for risk management: building scenarios based on the past. Sounds familiar? Isn’t that the usual approach in risk management (and what got all of us in big trouble) ?

Consider the following set-up: the Swiss Franc went for a secular rise during 2010, mainly because European Sovereign Debt markets were (and still are) ablaze due to unsustainable fiscal stances. The Swiss Franc, historically a safe haven for those who seek protection from devaluation and political unrest, is a very important risk factor for the Swiss economy given that the exporting industry’s terms of trade worsen every time the Swissie goes up. Stemming the tide using open market operations has been tried during 2010 with limited success. So what’s next?

Obviously, commentators quickly picked up this fairly popular topic and went looking for a past episode (which is rather easy in the monetary history of Switzerland). Negative interest rates on foreign Swiss Franc deposits and Gentlemen’s Agreements with banks against currency speculation were first to be cited. Now, that’s all very well, since these measures were implemented in the 1970s, when Bretton Woods was on its deathbed and the Swissie rose like a homesick angel. And because the international currency system is experiencing tremors as we speak, surely measures of this kind could be adequate.

Save for the dose of over-simplification and the slight whiff of populism that virtually always hang over the debate on over-valued currencies, diligent analysis definitely needs to account for the exact chain of events that led to decisions when they were taken. When looking into the chain of events that lead to foreign-exchange fees charged on foreign depositors (aka “negative interest rates”) and the Gentlemen’s Agreements against speculation, one quickly discovers that the market microstructure has fundamentally changed since then (just consider new participants in the market, like the much-reviled hedge funds, or new technology, like CLS or algorithmic trading). Hence, ideas of superimposing such scenarios on today’s environment are to be taken with a pinch of salt.

Which brings us back to risk management. The current emphasis on stress testing for both liquidity and capital, combined with the momentous changes we are witnessing, definitely calls for the inclusion of past events, and be it only for orders of magnitude of certain factors. However, because we come out of a period of relative calm and because market infrastructure, market structures and indeed technology have changed over the last 20-odd years, utmost care is needed when analyzing historical data. So, when investigating on how history might repeat itself, careful analysis of markets, chains of events and the then current regulatory environment are all to be taken into consideration when formulating scenarios for historical analyses.

So, while may have been trained (and very well) to apply stochastics to root out the limits of our imagination, re-learning to assess structures seems to be de rigeur going forward. To add insult to injury, one scenario only represents one chain of events, thus a whole range of scenarios need to be considered. This may sound sobering, given that the regulatory tsunami makes what is an already stressful period for risk managers even more stressful. But consider for a second the benefits of careful scenario building. Simulating scenarios on portfolios, business models, whole balance sheets even, take –if well formulated and broadly accepted- a pivotal role in transforming stress testing exercises from merely reporting risks to supporting actual business decisions. This in itself is highly valuable for organizations, since risk management will get more deeply engrained into their culture. The process of formulating, exploring and criticizing scenarios acts as a catalyst between business and risk management and helps, by anticipating future developments, financial institutions to steer clear of future icebergs. Hence, as much as it is useful to have healthy debates on currency issues in public, boardrooms and risk offices can leverage a good argument for Basel III.