Credit risk management is an essential aspect of any financial institution, and the use of models to assess and manage credit risk is becoming increasingly important.
To ensure that these models are effective and reliable, financial institutions need to have a robust Model Risk Management (MRM) framework in place. But what is a MRM framework and what are its essential components?
A model risk management framework is a set of procedures, policies, and controls designed to identify, assess, monitor, and mitigate the risks associated with the use of financial models in decision-making. The framework aims to ensure that models are developed and used in a consistent, transparent, and reliable manner, and that their outputs are accurate and appropriate for the intended purpose.
One key area of focus for model risk management is in the banking sector, where models are used extensively for risk assessment and regulatory reporting. In this context, two important models are the Internal Ratings-Based (IRB) approach and the International Financial Reporting Standard 9 (IFRS9) model.
The IRB approach is a regulatory framework used by banks to calculate their minimum capital requirements for credit risk. It relies on statistical models to estimate the probability of default, loss given default, and exposure at default for individual loans and other credit exposures.
IFRS9, on the other hand, is an accounting standard that requires banks to use models to estimate expected credit losses on their loan portfolios. The standard aims to ensure that banks recognize credit losses in a timely and accurate manner, and that they provide sufficient provisions to cover potential future losses.
Effective model risk management is essential for banks to maintain the integrity of their risk management and financial reporting processes. By implementing a robust framework that addresses the unique risks associated with each model, banks can enhance their ability to make informed decisions and improve their overall performance. Such a framework should have four essential components:
Model Inventory: A comprehensive model inventory is essential to ensure that all models in use are known, with their key attributes and documentation recorded. This is crucial for tracking a model’s performance and history, as well as identifying any potential issues that may arise.
MRM Governance Framework: This framework should clearly define all roles and responsibilities related to the management of models, both from a business and technical standpoint. It should specify who is responsible for developing, maintaining, and monitoring models, as well as outlining the processes for model approval and review.
Model Validation Framework: The model validation framework should outline the different types of tests and analyses that need to be conducted for each model type, as well as the frequency at which models need to be revalidated. It should also specify how to predict when models may fail and the criteria for determining whether a model meets its intended purpose.
Model Monitoring: Model monitoring involves the ongoing tracking of a model's performance and status in production. It is important to identify any potential issues that may arise and take corrective actions to address them promptly.
In conclusion, having a robust MRM framework is critical for ensuring that models used for credit risk management are effective and reliable. By implementing a comprehensive MRM framework that includes model inventory, governance, validation, and monitoring, financial institutions can identify and mitigate potential model risks, leading to more accurate and reliable credit risk assessments. We are trusted by our clients for our deep understanding of the regulatory environment, requirements and best practices for capital, accounting risk and credit decision models. As such, MetriQA produced and improved MRM frameworks for multiple clients. For inquiries, please visit the "Contact" page on our website.