What can we learn from the Bank of England Brexit scenarios? That most people miss the point of scenarios.
On 28th November 2018, Bank of England (BoE), UK’s central bank, published its EU withdrawal (aka Brexit) scenarios report[1]. It has, to say the least, drawn attention from a lot of people. Critics say it is playing politics, trying to scare people.
Like everyone else, I have my own views on Brexit. But let me try to give BoE scenarios a dispassionate assessment despite my own political bias.
To assess if someone does a good job or not, naturally we need to start by asking the question: what is the job? These criticisms quickly start to break down at this most fundamental level. The context is that on June 27 2018, the House of Commons Treasury Committee requested the BoE to conduct analysis of how leaving the EU would affect its ability to deliver its objectives for monetary and financial stability. Therefore these scenarios are not about “hoping for the best”. Instead, they are about “preparing for the worst”. They are not about what’s most likely to happen. It is not even about what could happen. It is about what could happen if everything goes wrong.
Using a finance jargon, these are stress testing scenarios. They are by design focusing on the negatives and they are by design extreme. You don’t read the side effect leaflet of a medicine and criticise it being too negative and too extreme. And yet Mark Carney seems very busy defending this report for being “highly speculative and extreme”[2].
This BoE story is a nice segue to think about scenarios in general: what scenarios are (and aren’t) about; why it is worth thinking about scenarios; and how they should be used by an investment organisation properly?
The what
A scenario, per my working definition, is a narrative description of a sequence of events (and possibly driving forces) leading to a plausible future state. The use of imaginative storytelling can make scenarios particularly powerful.
One of the messages that BoE kept repeating is that scenario is not forecast, which focuses on one – the mostly likely one – possible version of the future. Instead, it is about what could happen. Good scenarios need to be plausible. There is no requirement to be probable.
However, scenarios cannot cover the entire spectrum of all possible futures. Nor they are supposed to. Reading the BoE scenario report is far from making a financial institution Brexit proof. Do not let a sense of complacency or even security misguide you.
The why
Knowledge about the future is a key input to any decision – eg, even choosing between eating an apple and an orange relies on a prediction of future satisfaction. But if history teaches us anything, it is that the future is notoriously difficult to predict.
This poses a serious challenge to decision-makers. We still need to make sense of the future without the ability to accurately predict it. Here comes the role of thinking about the future in multiple scenarios. It is based on the belief that while complete knowledge about the future is impossible, we can still learn something useful about the future.
Another key benefit of thinking about scenarios is that it enables adaptive – second-loop – organisational learning. The mark of intelligence is the ability to learn. First-loop reactive learning connects the feedback the world gives us with the choice we make. Plan A didn’t work so well so let’s try plan B. This type of learning is natural and easy but only works in a stable environment and relies on fast and clear feedback.
Second-loop adaptive learning connects feedback with how the choices are made instead of the choices themselves. It leads to a re-assessment of the assumptions about how the world works. The management jargon is organisational mindsets. It is hard work and requires creativity but is critically important in a complex and fast-changing environment. The purpose of a scenario learning exercise is precisely to “unfreeze” and expand the current organisational mindset, supporting a culture of (second-loop) learning.
The how
So the key word here is learning. But it is not so much about learning about scenarios. Instead, it is more importantly to master learning with scenarios.
There is a strong supply of high-quality scenario reports in (and beyond) our industry (eg, CFA Institute, World Economic Forum). They are often read by individuals as research reports (often branded as “scenario analysis”) – in other words we often use these reports to learn about what could happen in future.
For scenario learning to be effective, it needs to go beyond just an intellectual exercise. For it to enable organisational learning, it has to be a social process. Collective learning is a collaborative, conversation-based social process – we make sense of the world together, not alone. Scenarios are used as a catalyst to make explicit and challenge the existing organisational mindset so we become more open-minded and are better prepared for the future. In this collective learning, scenarios are only a means to an end, not an end in themselves. We learn with them.
How this collective learning experience can be delivered in a pragmatic way in practice is explored in a forthcoming Thinking Ahead Institute research publication on scenario learning. It can be done in-house, given sufficient resource, or assisted by external facilitators. Preparation for a scenario learning exercise should involve setting clear objectives, and conducting pre-meeting polling. After the exercise, the lessons learned need to be captured.
Knowledge about the future
I sometimes find it useful to make a distinction between “unknowns” and “unknowables” in trying to deal with an immensely uncertain future. But one’s “unknowns” can be another one’s “knowns”. Together we can keep pushing the boundary of our collective “knowns” wider. And that’s what really matters given collective decision-making is the norm in institutional investing nowadays.
Another useful taxonomy is implicit versus explicit knowledge. We humans know more than we can tell. The issue with implicit/tacit knowledge is that it stays at the individual level until made explicit. In an interactive social process, we help each other interpret, clarify and convert implicit knowledge into explicit knowledge.
To me, scenarios are a great tool to build our collective knowledge about the future, but only if we can start to recognise scenarios for what they are.
