Introduction to Model Risk Management

The first step in creating a comprehensive and complete model inventory is setting a firmwide definition of a model’s materiality. Usually, the models with the largest financial impact come to mind first but there are other important areas to consider such as regulatory impact, customer and operational impacts and those models that feed into decision making.

The inventory should capture both internal and vendor models, and span across all departments. The materiality of a model can be measured using the model risks such as the potential of financial misstatement, reputational damage, customer impact or regulatory fine. Sometimes the simplest model can carry a lot of risk and often because these are viewed as simple models, they can get overlooked.

The exercise of creating a model inventory requires each model to be allocated a model owner and provides a starting point to embedding a strong model governance culture within the company.

The next step involves implementing a consistent model documentation process for the models within an organisation. This should clearly outline the standards required by the organisation when creating defined model processes, approval for model implementation and proper application of models across the organisation.

The term ‘Model Documentation’ is used a lot and can have varying definitions – it can mean anything from detailed process notes to higher level user guides. It is important to set clear guidance on the level of documentation required and who the readers of the model documents will be.

This ensures accountability around the effective execution of the model risk management programme including support from the board and senior management.

The success of a business will be heavily influenced by the quality and integrity of the models used. The model review process is a vital step to ensure the models remain appropriate. Reviews on a model can vary depending on the type of model and what stage of the lifecycle a model is at.

Typically, a model should undergo a series of checks by the user every time it is run and then be reviewed by a senior member. Independent checks or full model validation exercises are crucial for quality and integrity purposes, and these checks can be completed less frequently, and should ensure that there is no ‘model drift’ occurring.

Model risk assessments should be carried out to evaluate inherent and aggregate risk presented by a model. These assessments should cover the quality of model inputs, the effectiveness of the validation process, and provide ongoing challenge and review of models through quantitative and qualitative assessments.

Models used by a business will regularly be enhanced to reflect the economic outlook and changes in market conditions. Updates to a model should trigger a set of model change checks and any changes in methodology must be brought through the correct governance channels.

The materiality and sensitivity of a model should determine the frequency and extent of testing that should be carried out when developing and enhancing models. The roles and responsibilities should be clearly defined and evidenced – particularly around approval of changes to models and where judgements are being made.