Governance: The Return to Scenario Planning

(First of two parts)

By Christian G. Lauron

Looking Back: Stress Testing as a Governance Tool

First Published in Business World 1/09/2012)

In July 2010, we wrote about the supposed business objective of stress testing – i.e., to sufficiently forewarn management of an impending crisis in time to take mitigating action. Judging from the 2007-2008 global financial crisis, this objective has not been met due perhaps to the following:

• Stress tests in silos – Disjointed approach to testing by risk type or business unit and failure to share information across the organization.
• Lack of management buy-in – Misguided constraints on the range and severity of scenarios, and failure to explore and apply insights from the stress tests.
• Inadequate contingency planning – No early warning signals and contingency plans for a full range of stress scenarios.
• Poor methods and execution – Cross-risk and contagion effects were not considered, and there was insufficient automation or repeatability.
• Disconnected strategic planning – Stress tests were not incorporated into group strategic plans; business decisions were not aligned with the institution’s risk appetite.

Stress tests were supposed to determine a financial institution’s resilience to extreme and adverse events, by measuring how much of its capital could absorb the quantified losses of such events. We proposed a stress testing framework that integrated macroeconomic, capital sensitivity, and risk sensitivity stress testing, elevating stress testing into a matter of Board governance.

Forward to 2012: Resilience AND Performance

Financial firms, in particular, have begun investing in risk measurement and capital aggregation methodologies, tightened stress testing processes, tested the robustness of contingency plans, and explored strategically critical areas as transmission risks between the real economy and the financial sector, and between developed and emerging economies.

On the other hand, supervisors and regulators both here and abroad are raising the bar on the embedding of business use for the risk and capital reform agenda, potentially culminating in higher required capital charges and stricter capital quality definitions. They are also laying the foundation for systemic stress testing that will initially cover the banking sector, eventually expanding into a scalable network- or financial sector-wide stress testing to cover even financial transactions of non-financial sectors if there is a financial stability issue.

As economies and companies around the world start recovering, there is a growing sense, which is quite worrisome, that stress testing is becoming an organized exercise to yesterday’s paranoia. Boards now discuss the pressing need to transform the agenda from resilience to accelerated performance by examining strategic planning and aligning strategy, business and operations in a period of high uncertainty.

Is there any way that stress testing can become embedded in business use and a key to accelerating performance without diluting its purpose of forewarning impending crises?

Evolution of Scenario Planning

Scenario planning has continually evolved through the years. It has its roots in military strategy and warfare. From 1940 to 1960, first-generation (1G) scenarios were ‘explanatory scenarios’ used to emphasize possible future developments, such as the possible environmental effects of an atomic bomb detonation. During this period, scenario planning found further use in military studies, particularly by Herman Kahn and the Hudson Institute, to ‘think the unthinkable’ and assign probabilities of occurrence.

From 1960 to 1990, scenario planning found its more pronounced application in business when it was put into practice by one of the world’s largest oil companies. Through scenario planning, the company was able to develop early strategic options anticipating several potential outcomes of the oil crisis. This allowed the company to benefit from the crisis, emerging unscathed with a deep competitive advantage. These second-generation (2G) scenarios, called ‘decision-support’ scenarios as described by Pierre Wack, were used to assess a business’ dependence on relevant factors and their influence on decision makers.

The scenario planning espoused by Wack and Kees van der Heijden was about changing mindsets in response to images of exogenous events, prior to the conduct of strategy development, and identifying the ‘critical mass of intents’ that indicated potential or developing upheavals, upon which the prepared responses and option are activated. By the 1980s, scenario planning was a widely used technique by large US corporations, which paved the way for the use of scenario-based planning methods, attracting the attention of organizations with high capital investments and long-term planning horizons.

This evolution – from ‘think the unthinkable’ with probability assignments, to changing an organizational mindset, into becoming a process or method technique – also mirrors the shift in the management field from tactical to systems thinking, giving rise to shared thinking in ‘mental models’.

From Boundaries to Mental Models

At the turn of the century, several critical shifts occurred.

The Tequila Hang-over of 1994-1995, the Asian Flu of 1997, the Y2K scare, the Global Financial Crisis (with the US as the epicenter) of 2007-2008 and the related Global Commodity Crisis in 2008-2009, and the European Sovereign Network Crisis (or ‘Confidence’ Crisis) of 2011 — all generally point to the collapse of trade, financial and service barriers, the intermittent rise of financial bubbles that parallel ‘out-performing’ sectors of the real economy, and the testing of existing political and governance systems.

Geo-political, economic and other imposed boundaries are starting to give way to networks and macrocosms of “mental models.” Peter Senge defines mental models as “deeply held internal images of how the world works, images that limit us to familiar ways of thinking and acting. Very often, we are not consciously aware of our mental models or the effects they have on our behavior”.

As these wider, exogenous developments continue to take place, people talk about entering an “age of turbulence.” Companies were perceived to be operating in a stable environment from 2000 until the global financial crisis happened, and had been relatively successful in extrapolating the past to forecast the future. The gradual emergence of fair value thinking and reporting had the unintended effect of diminishing scenario planning into a largely sensitivity exercise.

Thus, scenario planning did not take root in the culture of companies. Viewed as a complex, time-consuming process, coupled with the turbulent times, the general unwillingness to deal with unpleasant situations and soft factors, and the lack of “hard numbers,” scenario planning was rendered inoperable or strategically irrelevant. The real benefit of scenario planning –i.e., comprehensive analysis and discussion, as well as systematic consideration of alternative future scenarios with truly variable factors – became its Achilles heel in the absence of an enabling implementation framework.

Scenario Planning in the Age of Uncertainty

The situation calls for a deeper understanding and reorientation of scenario planning. Scenarios provide alternative images of the future and include a consistent set of external factors over which the organization has no influence. It enables an organization to think ahead rather than to forecast future situations, without any assessment of the likelihood that they will occur (Broetzmann and Goetz of Ernst & Young’s Global Performance Thinktank).

There are three fundamental reorientations to be made. Scenario planning:

a. Is not about predicting the future but on facing NOW the alternative images of the future;
b. Is neither a sensitivity analysis (rendering it simplistic) nor a long-term forecasting exercise (making it disconnected); and,
c. Does not have probabilities for likelihood.

In next week’s column, we will look at specific strategies that organizations can consider as a framework for “operationalizing” scenario planning.

Christian G. Lauron is a Partner of SGV & Co.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.