📢 Chief Risk Officers (CROs) play a crucial role in today’s business landscape, particularly as financial institutions (FIs) increasingly rely on complex models. Model risk management is at the forefront of CROs’ minds. Welcome to post #8 of the CRO series!
🔍 What is a model?
A model can be defined as a quantitative method, system, or approach that applies statistical, economic, financial, or mathematical theories, techniques, and assumptions to process input data into output.
🔍 What is model risk?
Model risk refers to the potential for adverse consequences arising from model errors or the inappropriate use of model outputs in making business decisions. This definition encompasses risks such as deterioration in the prudential position, non-compliance with laws and regulations, damage to a firm’s reputation, financial losses, and qualitative limitations that may restrict business activities.
📈 How to manage model risk?
The recent supervisory statement SS1/23 by the Bank of England presents five main principles for a sound model risk management. These principles are:
1️⃣ Model identification and risk classification: FIs should establish a clear definition of a model, have an comprehensive inventory of its models and adopt a risk-based tiering approach to categorize models.
2️⃣ Governance framework: A strong governance framework is essential, encompassing clearly defined roles and responsibilities, oversight by the board and senior management, and well-documented policies and procedures. Regular assessment by internal audit ensures an independent review of the framework’s effectiveness.
3️⃣ Robust model development, implementation, and use: FIs should establish a sound process for model development, implementation, and use. This process should include standards for model design and implementation, model selection, and ongoing measurement of model performance. Regular testing of data, model constructs, assumptions, and outcomes enables the identification, monitoring, recording, and remediation of model limitations and weaknesses.
4️⃣ Independent model validation: FIs should have a validation process that provides ongoing, independent, and effective challenge to model development and use.
5️⃣ Model risk mitigants and Independent review: Established policies and procedures should be in place for the use of model risk mitigants when models under-perform.
🌟 It is crucial to remember that models are powerful tools, but they should always be used in conjunction with human judgment and expertise for an effective decision-making in managing risk.
📖 Stay tuned for post #9 of the CRO series, where we will discuss another top concern of banks’ CROs.
At Facultas-Risk Consulting Inc., we are your trusted partner, always ready to help you navigate opportunities and effectively manage risks.
Source: SS1/23 – Model risk management principles for banks, Bank of England, Prudential Regulation Authority (PRA), May 2023.