25th November 2015

4 Essential Elements of an Effective Model Risk Management Foundation

Written by Clayton Mitchell, Senior Manager at Crowe Horwath LLP

In the introductory blog post in our series on model risk management,we stated that a clearly defined model risk management framework can significantly enhance business efficiency and output quality, resulting in sound decisions and regulatory compliance. Although our financial institution clients usually understand the concept of model risk management, many are uncertain about the requirements for a successful model risk management programme.

The first and most fundamental step in achieving and sustaining an effective programme is to have a strong model foundation, which provides structure, consistency, and efficiency. Business and regulatory alignment, supporting documentation, enabling technology, and programme management are the elements that together constitute a sound foundation.

The Foundational Elements

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Source: Crowe Horwath LLP analysis

  1. Business and Regulatory Alignment

Models that are misaligned to the specific business of a bank or other financial institution will result in poor customer outcomes, inappropriate regulatory capital holding, and ineffective management of financial crime risk. In addition, regulators may deem a model risk management programme to be ineffective if business needs are not aligned to regulatory standards.

To achieve business and regulatory alignment, banks should assess models continually as business situations shift and regulations evolve. Processes, decision-making, and risk management activities should be adapted based those changes.

  1. Supporting Documentation

Simply put, if documentation that substantiates the model risk management framework is not in place, a regulator will assume that documentation does not exist. Documentation is vital for all areas of model risk management, including policies and procedures; model inventory and risk assessments; detailed support for model development, implementation, and use; periodic model validation results; and detailed calibration analyses.

  1. Enabling Technology

As banks increasingly rely on models to drive decisions and ultimately the business, the need grows for executives to establish enterprisewide standards for effective and efficient risk management mechanisms. Executives should use technology to implement a model risk management programme in a consistent manner throughout the organisation. Executives should use technology to:

  • Document all risk management activities consistently and effectively
  • Enable other processes, including model risk assessment, validation, and calibration
  1. Programme Management

Model risk management is ongoing and time-intensive. However, investing in it pays business and regulatory dividends as the programme matures and clear roles and responsibilities are developed. Model risk management is a relatively new concept in certain sectors, and it is important that those chosen to manage a programme not only have the skills and knowledge to execute their duties but also have functional capabilities and understand the models’ use.

A Stronger Programme

The stronger the foundation of a bank’s model risk management programme, the more effectively and efficiently the bank’s model risk will be managed. Adherence to the guidelines described here creates consistency throughout departments, functions, and activities that are critical to providing accurate and timely information to senior management, the board, and regulators. Adherence also sets the stage for other risk management activities, which will be the subject of future posts.

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