The evolution of model risk management processes

Abstract

Model risk is a relatively new area that only recently separated from operational risk. This paper provides an overview of what needs to be done in model risk management versus the older concept of model validation. The works published by the Federal Reserve and later by the European Baking Authority and Bank of England have helped to establish the foundations for a model risk framework. The real challenge for model risk is to evolve from a pure cost to a valueadded function for financial institutions. This journey requires the application of many elements, including a consistent model definition and performance monitoring of model risk in line with the risk appetite and business model of financial institutions. The final step is to identify a coherent and clear way to aggregate and report model risk to allow senior management to fully understand it in detail and integrate it in the broader risk management strategy.