Jan 2, 2014

Living In Peace with Financial Models: 2014 and Beyond

Model risk can no longer be ignored. As we ring in the New Year, what resolutions should financial practitioners make to better navigate the murky waters associated with model risk?

Financial models have become a necessary fact of life in today’s post-crisis financial world; yet we all know that model usage in and of itself remains an imperfect science—depending on underlying assumptions and methodology, implementation practices, and, of course, the quality of data used. Model risk, once considered something to yawn about, can no longer be ignored if one is to sleep at night.As we ring in the New Year, what resolutions should financial practitioners make to better navigate the dark, murky waters associated with model risk?

As with any type of risk, our goal as mere mortals can only be risk management. We will never be able to completely eliminate all risk involved in financial model usage. Even those of us once bold enough to believe we could were proven wrong by the very magnitude of the Global Financial Crisis (GFC). Yet financial models are here to stay, in 2014 and forevermore.

Quantitative models are now behind essentially all decision-making in the financial world—from trading and risk decisions,to meeting today’s increasing regulatory mandates. Advanced models are incredibly useful when it comes to dealing with large amounts of complex information and making critical decisions that allow financial markets to function. We have come to see that financial models can serve as man’s best friend—but can also prove to be our worst enemy.

When we look back to the multibillion-dollar losses faced by Long Term Capital Management in the late ’90s caused by poor model assumptions, or more recently to the nearly $14 trillion in losses that resulted during the GFC, what have we really learned? Clearly, we would be remiss if we did not also look at the missteps behind this year’s JP Morgan whale loss and VaR model debacle. It is no surprise that regulators have deemed it necessary to step in and provide enhanced guidance and regulations surrounding more effective model risk management processes.

But regulations aside, what can today’s organizations do to manage model risk processes effectively and to make sure that model risk is commensurate with model risk exposure? It is more important than ever for organizations to understand the risk factors and types of risk that they are exposed to, in a more holistic way.

Best Practices: Effective Model Risk Management Checklist

In addition to the best practices of using model classification and risk factor taxonomy analysis, we’ve developed a basic model risk framework checklist, which can provide a good launching point for organizations seeking to take a deeper dive into model risk management in 2014. The key aspects of an effective model risk framework should include:

  • Independence of various functions, in particular, the model development, risk control and audit functions
  • Clear definitions of ownership with accountability aligned with incentives and authority
  • Effective change management processes with checkpoints and defined criteria at each stage
  • Emphasis on documentation at each stage in the model lifecycle
  • Dissemination of model risk scores and user education along with model results
  • Recognition of models as a “work-in-progress” that need to be continually re-examined and improved, rather than as a one-time effort
  • Recognition of the fact that quantitative finance and technology skills are separate, but require close collaboration

In addition, there is a model life cycle that organizations should institute, with clear responsibility and ownership at each point of the process, which creates a continuous cycle of development as demonstrated in the illustration below:

Model Risk Control

Overall, we need to realize that effective model risk management has become a key source of competitive advantage, and a necessity, for today’s financial institutions to both survive and thrive.

This article orignially appeared as a contribution from Numerix to TabbForum's Mastering Risk Spotlight Series, you can read the contributed article here. For more on industry best practices on mastering model risk, see Numerix's recent white paper, "Mastering Model Risk: Assessment, Regulation and Best Practices."

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