How the Fed and World Leading Organizations Use Scenario Analysis and Financial Modeling
The Federal Reserve (‘the Fed’) is the central bank of the United States. It is tasked with providing the nation with a safe, flexible, and stable monetary and financial system. This is obviously a momentous task to accomplish, and there are countless variables and factors to consider when making critical decisions—decisions that may help avoid large-scale economic disasters.
Recently, Jerome Powell, the 16th chairman of the Fed, sat down with 60 minutes to discuss the latest economic developments, as well as the Fed’s response to the COVID pandemic. Powell’s insights reveal the vital role that forward-thinking scenario analysis plays in the very core stability of American (and, in turn, global) financial systems.
From a general risk perspective, Powell discussed various worst-case scenarios. One discussed the hypothetical scenario in which “a large payment utility breaks down and the payment system can't work. Payments can't be completed. You would have a part of the financial system come to a halt.” Rather than preparing to play the role of damage control, Powell stated, the Fed spends a significant amount of time, energy, and money guarding against such events happening in the first place. It’s also critical, he noted, for the Fed to plan for outcomes in which risks become reality and there is a severe shock to the financial system.
When queried on the Fed’s response to COVID, Powell shared that it was a period of tremendous uncertainty rather than one of panic. The aim of scenario planning, after all, is to model a range of possible outcomes—not to focus on an unrealistically optimistic or pessimistic viewpoint.
The reality was that no one had ever voluntarily shut down major economies around the world at the same time. They didn’t know what would happen, how long the virus would go on, or how severe the economic impacts would be. Instead, they discussed all possible scenarios, including a ‘Great Depression-esque’ downturn (which Powell admitted was around the edges of their conversations and modeling).
As the Fed’s approach to COVID response reveals, the key to being prepared for the unexpected is to consider all outcomes, their likelihood, and their potential impacts. These factors combined can be used to build a dynamic, meaningful financial model.
Critical infrastructure planning relies on scenario modeling
It is also worth taking a look at one of the areas of the economy (and of our daily lives) most heavily impacted by the pandemic: transport and infrastructure.
Andy Byford is the commissioner at Transport for London (TfL)—the network responsible for the entire transport system of a global city. Having previously overhauled the subway system in New York, Byford has seen every possible scenario that could occur when planning such a critical component of the physical economy.
A major part of managing a transport system is modeling the passenger load of each moving piece. Trains and busses need to run when people need them. Special events, inclement weather, seasonal variances, and many more factors must be considered. Investing in changes to infrastructure comes from a prediction of future demand and value generated.
The pandemic threw every base scenario entirely out of whack. “Bus ridership at the moment is around 40 percent. The Tube, around 20 percent of normal levels. At one point, the Tube was 5 percent of its normal ridership,” according to Byford.
In order to equip themselves to respond to whatever outcome may occur, Transport for London modeled five scenarios—from doomsday-level to overly optimistic. They took several questions into consideration: If ridership does not bounce back post-lockdown, how should the body respond? What are the financial impacts? What if the opposite happens and the demand is higher than anticipated, more rapidly than expected?
Similarly, the world’s largest gas and oil companies (BP, Shell, and the like) have been tasked with a significant repositioning in fortunes over the next few decades. Dwindling resources and a transition to renewable energy means that only those who transform their portfolios adaptively to a range of potential outcomes will maintain a sustainable business model.
There is a range of scenarios presented by the International Energy Agency and other significant bodies that put trillions of dollars at stake. Deloitte’s US oil and gas leader, Amy Chronis, implores that “The industry faces a conundrum to capture additional value from hydrocarbons businesses or put more capital expenditures into low-carbon ventures.” How major corporations model outcomes, including the likelihood of each scenario, is now critical to their survival as viable businesses.
In the current and future business environment, change is the only certainty. Leaders of top organizations know that modeling a range of dynamic outcomes is essential—and you should, too.
The benefits of advanced financial modeling and analysis tools
Clearly, financial modeling, including scenario analysis, is a critical component of top-performing organizations and institutions. It’s worth noting that financial modeling is not an entirely scientific process, with elements of input making accurate outputs a target but not a certainty. An iterative process to improve the model over time can generate better outcomes, as can making use of advanced analysis tools designed to optimize the process.
Advanced modeling allows organizations to develop:
- A rich understanding of the business. The more complex and involved the modeling process, the deeper the understanding required. Building a meaningful financial model forces the organization to think about itself internally, as well as the external factors that play a role in their drivers of performance. As the interaction of these variables is explored, insights will be proliferated that may not have been known prior.
- Deeper insights into cash flows. Dynamic modeling solutions provide a clearer view of how cash flows may play out in the future and under various scenarios. The relationship between financial metrics, such as revenue, expenses, and profits, may not be linear or predictable by fundamental regression analysis. Intelligent modeling software can provide a clearer picture of future financials, which, in turn, helps assess funding requirements, the appropriate mix of debt and equity, and much more.
- Develop more accurate valuations. In a similar vein, leading tools provide a more accurate basis for self valuation, pricing equity, and assessing potential acquisitions, internal investments, and prospective synergies that may result.
Financial modeling and scenario analysis are far more critical than many people realize. The Fed leverages complex financial models to help underpin the entire financial system of the United States—and, by extension, the global economy. In these large-scale examples, it’s clear to see that the ramifications and consequences, both positive and negative, of differing levels and approaches to scenario modeling are both significant and meaningful.
No matter the size of your organization, financial modeling and scenario analysis can play a critical role in extracting the most value from your strategic approach, direction, and financial position. Adequate forward planning allows operational and financial flexibility to deal with a range of possible outcomes for the benefit of your business and stakeholders. Management is empowered with insights that account for a range of possibilities, being prepared in near-real-time to make critical decisions.
Financial modeling software should be powerful enough to deliver these meaningful insights while allowing for flexibility and the consequences of an increasingly complex organization. If your company would like to learn how Synario can help your teams model the future to enhance your scenario analysis and decision making, get in touch with us today.