Profitable growth requires risk, and scenario planning can help financial institutions understand and effectively manage those risks to maximize profitability.
By creating “what-if” scenario analyses to inform reforecasting, finance teams can illustrate how changes in business drivers may affect the budget. Modeling different sets of conditions can assist in guiding budget and strategy decisions.
Pave your path to success with these five steps to effective scenario planning in your financial institution:
1. Incorporate Key Driver Assumptions
Identify the key short- and long-term drivers to the business. These include macro-economic conditions like GDP, unemployment rates, and the housing market; and institution-specific factors such as interest rate fluctuation, loan growth expectations, pricing spreads, credit quality assumptions, balance sheet growth for each category of assets and liabilities, expected fee income, cost projections, prepayment speeds, and liquidity.
To understand the impact of changing specific assumptions, remember to:
- Extract these variables from the business logic and test them independently to more easily quantify and change each assumption
- Track and maintain a historic trend of these drivers, using version control to replicate sets of drivers before changing assumptions to facilitate comparison
2. Ensure Transparency in the Business Logic Layer
Confirm that you understand the relationships between driver variables and financial outcomes, as reflected in the business logic layer. Make it transparent so planners can easily fine tune their models through back testing.
To do this, first input current driver values, and compare the calculated results to the latest actual results. Then modify the business logic based on this comparison to ensure reasonable forecasted values.
Axiom™ takes a unique approach to managing business logic by maintaining it directly in the database in the form of script logic. Keeping the business logic separate makes it far easier to understand and manage.
3. Establish Collaborative Input and Override Processes
Ensure that subject matter experts review the results of any driver-based process. The best scenario planning model enables robust computations but also allows users to adjust inputs or drivers, rather than the expected results. Use workflow logic to gain feedback and buy-in from appropriate stakeholders.
4. Define Scenario Storage Parameters
Store approved scenarios in a model repository, to ensure that:
- Planners can easily name, store, and retrieve scenarios
- Each scenario includes data, metadata, user input, and calculations
- The Plan Administrator defines easy-to-understand names for each scenario
Axiom leverages a relational database structure to support scenario planning. This structure allows for easy saving and retrieval of every element and aspect of the scenario.
5. Present Scenarios Intuitively
Utilize side-by-side comparisons that include key drivers, financial information, and narratives around the contents of the scenario. It’s critical that those reviewing reports or dashboards with scenario results can quickly see the detail and optionally review the business logic that’s driving results. Simplicity in this process is essential, so that the planning model isn’t a “black box.”
Forecasting under various sets of conditions is key in uncertain markets. For example, consider modeling a V-shaped recovery, with a quick low and rapid improvement, versus a U-shaped recovery, with a longer period of unfavorable conditions.
As a leading practice, run scenarios both to understand the potential impact and risks, but also to evaluate what your plans will be if those scenarios start to take shape. You cannot afford to react after the fact — financial institution leaders must understand and prepare to respond when one of those scenarios becomes reality.