As financial institutions increasingly rely on models to inform decision-making, model risk management has become an important area of focus for regulators and financial institutions alike. But what exactly is model risk? And what are some of the most popular model risk management frameworks?
What is Model Risk?
Model risk is the potential for losses incurred by a financial institution as a result of reliance on inaccurate or imprecise models. In other words, it’s the risk that the conclusions drawn from a model may be wrong.
There are a variety of sources of model risk, including but not limited to incorrect or imprecise assumptions, data errors or problems with input data, and errors in model formulation or coding. Model risk can lead to losses in a number of ways, including inaccurate pricing of products, incorrect assessment of counterparty credit risk, and miss-selling of products to customers.
Due to the potential for losses, regulators require financial institutions to have robust models management frameworks in place. A model risk management framework is a set of policies and procedures designed to identify, assess, monitor, and control model risk.
Some of the most popular model risk management frameworks include:
- The Three Lines of Defense Framework
- The Senior Managers and Certification Regime (SM&CR)
- The Federal Reserve’s Supervisory Framework for Model Risk Management
- Basel Committee on Banking Supervision’s Sound practices for the development and use of banks’ internal models
- European Banking Authority Guidelines on Outsourcing Arrangements
Each framework has its own strengths and weaknesses, so it’s important for financial institutions to carefully consider which one is best suited to their needs.
Model risk has become an increasingly important area of focus for both regulators and financial institutions in recent years. Model risk is the potential for losses incurred by a financial institution as a result of reliance on inaccurate or imprecise models. There are a variety of sources of model risk, and model risk can lead to losses in a number of ways. Due to the potential for losses, regulators require financial institutions to have robust models management frameworks in place. Some of the most popular model risk management frameworks include the Three Lines of Defense framework, the Senior Managers and Certification Regime (SM&CR), the Federal Reserve’s Supervisory Framework for Model Risk Management, Basel Committee on Banking Supervision’s Sound practices for the development and use of banks’ internal models, and European Banking Authority Guidelines on outsourcing arrangements. Each framework has its own strengths and weaknesses, so it’s important for financial institutions to carefully consider which one is best suited to their needs.
