Magazine article The RMA Journal

Model Risk Management: Identifying Trends and Divergences in Frameworks and Life Cycle Implementation

Magazine article The RMA Journal

Model Risk Management: Identifying Trends and Divergences in Frameworks and Life Cycle Implementation

Article excerpt

IN A TWO-PART SERIES, the author discusses the results of a survey that sought to identity emerging model risk management (MRM) best practices and key implementation challenges in a more demanding regulatory environment. Part 1, in this issue, discusses model risk scope and definitions as well as the MRM framework. Part 2, coming in the November issue, will focus on the MRM life cycle and its implementation challenges along with future considerations.

Financial institutions employ a wide range of models of varying complexity across various business areas to support their day-to-day activities. Thus, management of model risk can be considered a multidimensional and cross-business challenge. It requires implementation of a robust and consistent firm-wide framework that governs management of model risk across different model families. That framework is delivered through controls and effective challenge provided by different functions across the whole business with oversight by the board and senior management.

A recent survey conducted by Deloitte LLP took a holistic view of model risk management (MRM) and covered questions related to the following:

* Model risk scope and definitions.

* The MRM framework, including model risk governance, policies and procedures, and roles and responsibilities.

* The MRM life cycle, including model risk identification and assessment, measurement and mitigation, and monitoring and reporting.

* Implementation challenges and further considerations.

The survey involved 24 financial institutions worldwide and was conducted in the winter-spring of 201516. The institutions ranged in asset size from approximately $70 billion to $2.3 trillion.

Executive Summary

Model risk management is still a relatively new area of risk management. Financial institutions have invested significant effort over the last five years in establishing their enterprise MRM frameworks and integrating the MRM life cycle into their day-to-day business activities. This effort has not come without challenges. Among them are a lack of clear strategic business direction with regard to MRM and difficulty in finding adequate resources given rapidly evolving regulatory requirements, expanding interpretation of the same regulatory guidance, and a continuously evolving industry notion of effective MRM practices.

Another key challenge is the consistent application of the MRM process to all model families across different business areas and geographical locations. Survey results showed that while financial institutions' definition of a model is quite broad--and a wide range of tools across different business areas fall under it--the MRM process in many cases is applied only to specific model types, typically those with regulatory oversight. Thus, the key development area for the majority of financial institutions is the need to introduce a holistic view of model risk to cover all aspects of the model life cycle and to apply it consistently to all models in use that satisfy the enterprise model definition.

The survey identified certain trends and divergences in both the setup of MRM frameworks and implementation of MRM life cycles, which are summarized below.

MRM Framework

All institutions participating in the survey have enterprise-level model risk policies or standards describing their model risk frameworks along with assigned roles and responsibilities, while setting minimum requirements for the MRM life cycle. Enterprise policies are supplemented in some cases by standards specific to the business line or model family, which include additional or more detailed requirements, controls, and procedures.

The biggest differences come in the governance structure and setup of control functions. Institutions with more mature MRM frameworks have both the board and senior management (in the form of model-risk-related committees) providing oversight at the top level, although the board reporting is still in the early stage of development for many financial institutions. …

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