OVERVIEW

One crucial issue in risk management deals with analyzing what could go wrong with individual credits and portfolios and factoring this information into the analysis of risk-adjusted returns, capital adequacy, and loan provisions. "What if" analysis can unveil previously uncovered areas of credit risk exposures and plays the vital role of locking into areas of potential problems. This chapter explains how to process scenarios through various forecasting techniques ranging from modified percentage of sales to advanced stochastic optimization analysis.

The Basel Committee on Banking Supervision has this to say about forecasting:

In the final analysis banks should attempt to identify the types of situations, such as economic downturns, both in the whole economy or in particular sectors, higher than expected levels of delinquencies and defaults, or the combinations of credit and market events, that could produce substantial losses or liquidity problems. Stress test analyses should also include contingency plans regarding actions management might take given certain scenarios.

The emphasis on bank forecasts developed as loan demand increased to fund large and complex credits including mergers and acquisitions. These new deals represented a new class of borrowers who pushed their financial structure to exceedingly high debt levels. As a result, lenders began to work with a new breed of sophisticated forecasting and valuation models to predict expected default, financial needs, and shareholder value with a great deal more accuracy and insight.