AQ067-3-3-FRM
INDIVIDUAL ASSIGNMENT
INSTRUCTIONS TO CANDIDATES: FINANCIAL RISK MANAGEMENT
Individual Assignment. SUBMITTED TO:
Nalini Gebril
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JULY 22, 2022
this module.
Table of Contents
I. Introduction to Model Risk
II. Sources of Model Risks
III. Characteristics of Model Risks
IV. Model Risk Management Framework
V. Conclusion
VI. References
Introduction To Model Risk
The risk that could result from employing a poor model to guide decisions is known as
"model risk." At different stages of the model's life cycle, including development, validation,
implementation, and use, model risk can appear. It is frequently considered to be an element
of operational risk. There is a chance that one or more aspects will be overlooked in the
calculations or inaccurately represented in the model's output because a model is, by
definition, a reduced version of reality. These estimates' imprecise assumptions might cause
businesses to make expensive mistakes. ([Link], n.d.)
The emergence of complex quantitative models has made dangers more noticeable and of
grave concern. The models' possible mistakes as well as the proper application and use of the
models are the key causes of the risk. (CFI Team, 2021). Predictive models are being swiftly
incorporated into an increasing number of business operations thanks to the big data
revolution of recent years. Although this has many advantages, it also exposes institutions to
more risk, which can lead to operational losses. The results of making business decisions
based on flawed models might be disastrous. Automated machine learning, however, can aid
in lowering these hazards. (Oppenheimer, 2022)
IFRS 9 [Framework Implementation and Forward-looking integration]; FRTB, IRB Models
& TRIM; and ECB Regular Stress Tests are just a few of the concurrent rules that banks will
have to construct models to comply with in the coming years, according to a Deloitte article.
Banks should incorporate the risk appetite framework into their model risk limitations. Faster
model implementation, simplified procedures, and centralized modeling infrastructure are the
components of model risk lifecycle efficiency. By having a fundamental grasp of how banks
construct, document, utilize, monitor, set up and maintain, validate and control models for
credit, financial, and marketing activity inventory, we can increase model risk governance.
We advise you to go to this workshop. (Risk Advisory | Deloitte, 2017)
Before the 2008 financial crisis, the financial services sector managed risk using industry best
practices rather than legal requirements. Regulators have been seeking to reduce model risk
across the financial industry ever since the financial crisis. (Oppenheimer, 2022).
Sources of Model Risks
Risks can originate from many different places. Missing risk factors, incorrectly defining the
stochastic processes behind the model, or omitting critical variables are all significant
components of the model definition. Risk is frequently generated through the improper
application of models. This may be from choosing the incorrect model for the issue at hand or
from employing an outdated model. Another kind of model risk is implementation risk,
which often shows up when a user with limited understanding tries to mechanically
implement a model as a black box in a complicated environment. (ECB, 2007) Several of the
model dangers' sources are described below.
1) Data
A model may employ data that is unreliable, lacking, or skewed. Because building a
strong model is crucial, data that is inaccurate can have a significant impact on the
entire system.
2) Model implementation
The outputs of the model and the decision-making process may be adversely affected
by inaccurate or erroneous results if the model is not implemented properly.
3) Methodology
When used to predict outcomes, statistical techniques can result in errors like
sampling errors and standard errors. Regression models are susceptible to these
mistakes.
4) Parameters and assumption
Realistic system assumptions can aid in stabilizing the system, but erroneous
assumptions might cause instability. This is a risk because it can have unintended
repercussions. Model calibration may occur as a result of an error when fitting model
parameters.
5) Misuse
A model's utility can be revoked by improperly applying its constraints.
6) Interpretation
If a user doesn't comprehend the model's underlying assumptions and procedures, the
outcomes of the model may be misconstrued. This could have negative effects since
an inadequate plan could be created based on false information.
7) Inventory
The model risk might result from inaccurate and incomplete inventories. This could
indicate that the forecasting models being employed are not as precise as they could
be, which could result in losses for the business.
Some model users and developers who are very educated about the models may not
be keen on documenting them because it can take a lot of time and work. Banks must
ensure that other players in model risk management activities, including
benchmarking, outcomes analysis, continuous monitoring, and process verification,
document their work and offer incentives to developers to produce comprehensive
and effective model documentation. (Opara, 2021)
Characteristics of Model Risks
Some model users and developers who are very educated about the models may not be keen
on documenting them because it can take a lot of time and work. Banks must ensure that
other players in model risk management activities, including benchmarking, outcomes
analysis, continuous monitoring, and process verification, document their work and offer
incentives to developers to produce comprehensive and effective model documentation
(World Finance, 2010). Financial models are instruments that aid in the forecasting of future
events, such as shifts in market prices and prevailing economic conditions. They are
frequently generated using mathematical formulas and are simple enough for economists and
financiers to understand. Therefore, all models in this category can be thought of as
predictive tools that can provide explicit or implicit scenarios regarding how economic or
financial variables will develop in the future. When models are applied to risk assessments
frequently found in the financial services industry, model risk can also be thought of as
secondary risk (risk variables that contribute to inadequate risk management). (Opara, 2021)
The best ERM models were discussed with his colleague, according to an article by Segal
(2013). A Solvency-II-type ERM model, according to the colleague, is the only one needed
for an ERM program. By estimating distributable cash flows that are consistent with the
firm's strategic strategy, an ERM model that is based on values establishes a baseline
company value. The inherent risk is then taken into consideration by deducting this amount.
These are two streamlined approaches to completing a task. Instead of going into depth about
them, we instead focus on four aspects that, when applied to a primary ERM model for an
entity, can lead to model risk:
I. Complexity
A Solvency II approach necessitates numerous intricate computations, which can be
labor-intensive. This raises the model's risk, which includes flaws in the model itself,
mistakes made during form operations, incorrect interpretation of the model's output,
and detrimental consequences on risk culture. Utilizing a value-based strategy will
help you lower your model's risk and increase its dependability. A model's
dependability is a crucial component in determining whether management will use it
to make decisions.
II. Transparency
Financial industry specialists utilize the intricate Solvency II model to forecast how a
firm will perform financially. Most people find it challenging to comprehend the
model's outputs, let alone to communicate them to management. One of two
undesired results—neither of which is desirable—is frequently the result of a lack of
transparency. Few technical experts, in whom the management has complete faith, are
referred to in major choices. This dependence causes issues because management
doesn't completely comprehend the calculations guiding important decisions.
Everybody may utilize a value-based strategy because it is clear and simple to
comprehend. It is the most effective strategy for success. The model is founded on
expected cash flows and risk scenarios.
III. Inputs
In order to estimate risk, a Solvency II methodology significantly relies on outside
metrics and algorithms. It can be challenging to infer risk from a company's financial
information because both market valuations and the balance sheet can be deceptive.
There are a few risk factors, nevertheless, that warrant attention. The formulas that
depict the risk distributions are created using this data. Models that operate
automatically are created by using the equations to produce random risk scenarios.
Internal subject matter specialists, therefore, have few opportunities to share their
knowledge. Value-based techniques, on the other hand, quantify risk using internal
and expert methods. Risk data is generally gathered from in-house subject matter
experts who can analyze and weigh all relevant data, including market data, outputs
from stochastic models, etc., before selecting the deterministic risk scenarios they feel
accurately depict the risks. distribution of risk
When circumstances change and subject matter experts or management conclude that
there is a change in risk, the risk scenarios can be changed to reflect the new
information. The idea that a corporation's risks are better understood by the market
than by the company itself is implicit in the Solvency II methodology. The value-
based approach is predicated on the notion that internal company specialists, who are
closest to the business, are in the greatest position to provide an accurate assessment
of the numerous risk scenarios that may materialize and how each scenario risk will
operate. your progress inside the company.
IV. Basis
Models based on Solvency II have an unnatural and unrealistic worldview. They think
that everything is risk-free and predictable by the market, but this isn't always the
case. According to this concept, your income cannot increase beyond the rate at which
you can make money without danger. Any business has a market value equal to the
market value of its constituent parts. Since management must function in the real
world, the value-based approach is firmly grounded in the conviction that the ERM
model will be beneficial as well. the extent to which they estimate how those risks
will affect cash flow using realistic risk scenarios
In an ERM program, a wide variety of models can be helpful and encouraging.
However, in order to be effective, businesses should adopt the ERM model that is
most closely related to decision-making as their main model, preferably one that:
Convenient enough to preserve dependability and manageability of complexity
Sufficient in their transparency to win over the decision-makers
Adaptable enough to absorb input from internal sources (Segal, 2013)
Model Risk Management Framework
Model risk management is the process of keeping an eye on potential dangers that may arise
from decisions made using models that are either wrong or being used improperly. Utilizing
techniques, procedures, or behaviors that will recognize, assess, and reduce model risk—the
potential for model blunder or error—is the aim of model risk management. Credit, market,
and behavioral models are heavily used by financial institutions like banks and insurance
firms for a range of objectives that cover almost all of their daily operations. These models
are now an essential part of risk management and operational effectiveness. These
organizations mostly engage in risk-taking and profit-making. Maximize your model's
potential, evaluate risk, comprehend client behavior, specify funding needs, gauge capital
adequacy, choose investments, and handle data analysis. Organizations that extensively rely
on quantitative models of operations and decision-making must implement an effective
model risk management system. (Opara, 2021)
The risk departments of banks, insurance companies, asset managers, and some governmental
organizations, such as the VDAB (Flemish Employment and Vocational Training Service),
are the ones most concerned with model risk management, and in general, maximizing
(machine learning and traditional) models in high-risk environments. These businesses can be
non-financial firms in the domains of logistics, human resources, energy, healthcare, etc.
(Opara, 2021)
An enterprise must create a framework for model risk management to manage model risks
effectively. A framework for managing model hazards outlines the management of risks in
models. Regulators demand that enterprise model risk management frameworks include all
crucial aspects of the MRM life cycle with clearly defined roles and responsibilities,
regardless of the size and structure of a business.
Model risk management offers a thorough investigation of the pillars listed below in the
context of more broad risk management frameworks.
1. Modelling Risk Standards
A model should be developed in a way that complies with minimum requirements. These
norms ought to be adhered to and honored. In comparison to regulatory standards like the
Model Risk Management Regulatory Guide, internal standards should be at the same level or
higher (SR 11-07). Standards for data quality, model modifications, model application, expert
judgment, model methodology, model validation, documentation, external model data, and
model reporting should all be considered.
2. Model Risk Appetite
A statement of the board's tolerance for model risk should be included in a risk policy to
support efficient model risk management. Danger appetite refers to how much risk a
company is willing to accept in order to achieve its objectives. The goal for which the model
is implemented will determine the level of risk appetite for model risk. The model's risk
appetite should be expressed in terms of acceptable risk as well as different pertinent
indicators, such as the total number of high-risk models and cumulative quantitative risk
exposure.
3. Model Risk Identification
To effectively manage the risks that the company faces, it is critical to define their specific
nature. To determine any model modifications that could be necessary, an inventory of the
current models should be done. This will make sure that any necessary adjustments are made
and that the models are as accurate as feasible. A model inventory should contain details on
the model's name, purpose, method of usage, frequency of use, and assumptions or inputs that
went into its development.
4. Model Risk Assessment and Measurement
A quantitative and qualitative risk assessment is required to evaluate the risk connected to a
model. This evaluation examines the model's general viability as well as any potential
drawbacks. A framework for enterprise-wide risk assessment will be created using the two
methods. This framework will assist companies in identifying and evaluating the risks related
to their operations and activities. Model risk quantification measures risk using a variety of
techniques or an operational risk model approach. Specifically, there are three primary
methods for quantifying risk:
Sensitivity analysis: monitoring of shifting results and modifications to model
assumptions and criteria
Backtesting is the process of testing a model using historical data and contrasting the
findings with the output.
Challenger models compare one model's findings against those of another model that
uses the same data.
The appropriateness of the model is taken into account during the qualitative risk assessment.
The outcome shows how reliable the model is, which has an impact on how risky the model
is rated. The use of qualitative metrics to quantify risk in a model is taken into account by a
qualitative evaluation, which specifically takes into account the model's adherence to
standards, total model mistakes, the scope of the model's risk assessment, and other
qualitative aspects.
5. Model Risk Mitigation
Several ways for risk reduction are possible:
Modifications to the model development procedure
Consider changes in the nature and structure of current risks as well as the
introduction of new risks to which your company is exposed when performing
supplemental model validation.
use of impartial expert opinions to assess model results in light of model uncertainty.
Respect for the model and compatibility with new risk management guidelines.
Risk can be reduced by taking steps to increase the model's effectiveness and
applicability, including adding more cash.
6. Model Risk Monitoring and Reporting
The goal of the model risk monitoring and reporting function is to
To make sure the risk appetite is appropriate and the model risk policy is being
followed.
If there are differences, the procedure suggests that management involvement is
necessary.
To determine if a model is being used per the mrm policy framework, you must do a
material model inventory for each model.
To determine if any flaws have been found, the findings of a risk assessment and
validation should be examined. If necessary, corrective action should then be
implemented.
A summary of new developments in model risk management and any pertinent
concerns. (CFI Team, 2021)
MRM can go above and beyond what regulators are satisfied with and is more valuable than
regulators think. Financial organizations must ensure that the entire value of their consumers
is captured by their MRM frameworks. This is crucial since it ensures that clients are happy
and that the bank is utilizing its resources wisely. Analyzing the potential value of the data
being utilized in the model is the first step in risk management for models. Together with the
validation function, this is carried out to guarantee the model's accuracy. (Opara, 2021)
Improvement of Profit and Loss in Organizations using MRM
Keeping costs as low as feasible while lowering the likelihood of financial losses is the aim
of risk management. Capital reduction, loss avoidance, and cost reduction models are some of
the ones used to calculate risk. Each year, it grows harder to meet the goals of cutting
expenses, avoiding losses, and capital costs. This is because new paradigms, such as artificial
intelligence (AI), the war for talent, and new regulatory frameworks have been introduced.
To industrialize model risk management, several financial institutions are looking for new
methods. People frequently have very different expectations of themselves than what they are
capable of. This may cause them to feel disappointed and frustrated, which may be
detrimental to their general well-being. Financial institutions can prevent expensive capital
add-ons by proving their MRM program is current and effective. Making informed financial
or business decisions requires the use of complex models, but if these models aren't executed
properly, they can harm reputations and result in financial losses. Eliminating flawed models
and improving operational effectiveness in model development and validation are the main
ways to reduce losses and cut costs.
By tackling flawed model processes and a lack of ownership of over-complicated models,
model risk management helps to lower the cost of modeling. By establishing a data
automation plan, organizations can save millions of dollars. Organizations may benefit from
using this tactic to gather, store, and analyze data more effectively. Then, with this
information, businesses may make wiser decisions, enhance their operations, and boost sales.
Understanding the landscape of their models helps banks better match their investments in
models with business priorities and risks, lowering model risk and management complexity.
MRM also aids in lowering P&L's unpredictable nature. Transparency in model construction
and institutional risk culture are both significantly impacted by the all-inclusive effect.
Receiving resources that are redistributed from cost reductions will help high-priority
decision-making models be used more successfully. (Opara, 2021)
Conclusion
Model risk is frequently discounted as a minor aspect, and occasionally it is completely
disregarded. But neglecting model risk might have a negative impact on risk management. As
financial innovation continues to push the edge, we must either develop new models or
modify existing ones to consider all potential outcomes. Prudence advises that we should
continuously consider what can happen if our models are incorrect. As the events surrounding
the recent market volatility show, disregarding this fundamental premise could compromise
effective risk management at the corporate level and cause disruptions in wider financial
markets. (ECB, 2007)
References
CFI Team. (2021, July 23). Model Risk - Overview, Sources, and MRM Framework.
Corporate Finance Institute.
[Link]
ECB. (2007, December). MODEL RISK: AN OVERVIEW OF THE ISSUES. ECB.
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ecb~12db3d156b.fsrbox200712_14.pdf
Opara, C. (2021, April 6). What is Model Risk Management? [Link]. [Link].
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Oppenheimer, D. (2022, April 29). What is Model Risk and Why Does it Matter? DataRobot.
[Link]
Risk Advisory | Deloitte. (2017). Model Risk Management Driving the value in modelling.
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[Link]. (n.d.). Model risk definition. [Link]. Retrieved July 20, 2022, from
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Segal, S. (2013). Article from: The Actuary Magazine.
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