Model Risk Management for Financial Service Firms

July 1, 2008 ERM Initiative Staff 2-min. read

The emphasis on model risk management began in the national banking area after the Office of the Comptroller of the Currency (OCC) released a risk bulletin in 1997. The report, authored by Richard Pace, expressed the concerns of the OCC that the risks related to the use of credit scoring models were not being effectively managed. Some of the major concerns included:

The inadequate training of bank staff to monitor the model’s performance
Deficient bank management information systems
Inconsistent use of credit scoring models

The OCC set expectations for bank management in order for these organizations to resolve these concerns. A few years later, a couple of new concerns forced the OCC to release in 2000 a second risk bulletin. This bulletin focused more broadly on models used in banks’ risk management processes. Through the release of the risk bulletins and with the recent economic climate, the focus on model risk management has expanded outside of depository institutions and into other financial services organizations.

The 2000 bulletin led to many new developments in the model risk management area. Many companies developed formal model-validation policies and procedures to ensure that a bank’s model-validation efforts were consistent with senior management’s view of the proper trade-off between costs and benefits. The bulletin emphasized that an institution should develop and implement effective model-validation procedures, such as:

Comparison of the model’s results to other models
Independent review of the logical and conceptual soundness of the model
Comparison of model predictions against subsequent real-world events

There are many challenges associated with an effective model risk management program. A couple of current challenges that organizations face are:

Defining the scope of a model-risk management program
Determining appropriate roles and responsibilities for model-risk specialists
Effectively integrating the model on a cross-functional basis

This white-paper discusses the major challenges that organizations are currently dealing with regards to model risk management. It also provides suggestions and examples of how organizations can appropriately address these challenges.

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Original Article Source: “Model Risk Management: Key Considerations for Challenging Times,” PwC, July 2008