Model risk management

Model risk represents the unfavorable consequences arising from inappropriate model usage, incorrect model outputs, or due to errors in model implementation resulting in operational, financial and/or reputational losses. Globally, an increase in the number and complexity of models adopted by the financial sector institutions across various aspects of their operations, including capital computation, credit risk, market risk, operational risk, liquidity, pricing, fraud detection, etc, have necessitated implementation of holistic Model Risk Management (MRM) frameworks to manage model risks.

High profile examples of model failures coupled with increasing global uncertainty and disruptive systemic events like the 2020-21 pandemic have called for a need for a structured approach to managing model risks and mitigating model losses. In addition, the use of MRM across the financial sector has also evolved driven by increasing regulatory oversight in this area. Leading regulators have provided guidance on the MRM process, covering identification, management, mitigation and reporting. In the region, the Central Bank of the United Arab Emirates (CBUAE) issued the Model Management Standards and Guidance (MMS&G) in December 2022 aimed at improving model quality, homogeneity and ensuring mitigation of model risks.

The Saudi Central Bank (SAMA) is also expected to roll out MRM guidelines soon given the increasing pace of growth, digitization, and complexity in the Kingdom’s financial sector. Implementing a robust MRM framework is expected to result in improved decision making, enhanced efficiency, loss avoidance and capital optimization for the banking sector. Ensuring readiness to comply with upcoming SAMA MRM guidelines has thus become one of the key strategic and regulatory imperatives for the banking sector. This publication is presented to provide guidance for executives to implement MRM in their banks. We hope you find this insightful and look forward to feedback.