Model Risk Management (MRM). One may wonder why talk about it now when it’s been nearly 3 years since the OCC guidelines were published. But before that let’s define MRM. It is the integrated process of managing model risk through a model’s entire lifecycle and in the process ensure a governance rhythm that is regulations compliant. Similar to OCC, various countries have framed regulations that could impact model governance. And this is a first in a series of blogs that can highlight the regulatory requirements and model governance parameters.
To come back to why I am writing about this today. We see two trends that are shaping up the early adoption of MRM practices by the Banking industry in the US and worldwide.
1. Operational risk has surpassed Credit risk as the most important risk in Financial Services
Operational risk is the risk that organizations carry due its processes, people and systems. With increasing scrutiny over the need for governance and oversight, operational risk then becomes one of the most important risks to manage as it is the risk most inherent to an organization’s DNA. The quantification of this risk has led to new development in analytics capabilities across the world.
Operational risk then does warrant consideration from decision makers. Model Risk, the risk that emerges from inefficient, faulty models is one of the most important aspects of Operational Risk. The ever-increasing usage of quantitative models for decision making coupled with high complexity and low shelf life does demand a sizeable consideration from organizations
2. MRM solutions are being increasingly positioned as profit enhancing capabilities
Now, this is an aspect that I find a little worrisome. If one observes the OCC guidelines in detail, one will see that it lays down a ‘should-be’ state of model development, validation and governance functions within an organization. This means that MRM needs to be viewed as ‘must-do’ for organizations irrespective of Banks’ financial performance vis-à-vis profits.
But what we see today is MRM solutions being positioned as profit-drivers which again brings to the fore a fundamental question: How effective & unbiased will a Model Governance solution be if it’s chasing a profit margin.
The following graphic illustrates what OCC says about Model Risk Management.
Although, this seems quite intuitive at first, there are a few fine areas which require immediate attention and redressal.
1. Redefine Independence of Modelling Functions
Just an independent Validation team won’t cut it today. It is the independence of Development, Validation and Governance that will constitute an effective end-to-end MRM solution. Considering that a certain model will move across all these functions (and other functions within the organizations), it becomes imperative that there be strict access controls and privileges to concerned people in the organization and a way to monitor and govern all these stages.
2. Governance (for internal and external regulatory compliance)
Why stress on Governance so much when it is just one part of the entire MRM process. Although, the ‘for-profit positioning’ is prevalent, the primary motivation for Banks to define their MRM practice is still Regulatory Compliance. An independent Governance team armed with the right tool can go a long way in ensuring compliance. With Big Banks now defining senior Governance roles, the importance of this function will only grow. A robust workflow to govern models is the primary need for a Governance team trying to ensure internal and external compliance to processes, systems and people (read: Operational Risk)
3. Active Performance Monitoring
One may wonder, why talk about Performance monitoring if the MRM activity is motivated mainly by Regulations. As a bank, even if MRM practices don’t directly affect profits, it surely goes a long way in improving efficiency and bringing a unified view on model performance. Active monitoring not only shortens the cycle from issue detection to resolution, it drastically improves Governance visibility towards deterioration in model performance and the efficiency of all independent teams that come in the ambit of MRM.
There is a lot of thought put into model development and to an extent, validation. But effective Model Governance is the magic pill that will enable MRM to truly integrate into an organization and eventually, but indirectly help grow the organization.
- Enabling a well-defined model governance process that addresses regulatory needs
- Single repository for all models: auditable & transparent.
- Visibility to leadership team – objective, consistent assessment of model risk.
- Proactively identifies performance issues & drill down to key drivers.
- Automated to reduce time & effort, to deploy & track models (any frequency).
This blog is written by Ajinkya Adhav, Analytics Project Manager at BRIDGEi2i
About BRIDGEi2i: BRIDGEi2i provides Business Analytics Solutions to enterprises globally, enabling them to achieve accelerated business impact harnessing the power of data. Our analytics services and technology solutions enable business managers to consume more meaningful information from big data, generate actionable insights from complex business problems and make data driven decisions across pan-enterprise processes to create sustainable business impact. To know more visit www.bridgei2i.com
The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position or viewpoint of BRIDGEi2i.