Model Risk Management - Reshaping of the independent validation function of financial risk models

THE CLIENT

The client is one of the largest public development banks in France, specialized in financing the local public sector but also in the refinancing of credit export contracts.

THE CHALLENGE

Under the annual SREP exercise, the ECB concluded that the bank did not have sufficient quantitative capabilities or resources to properly conduct either independent model validations or internal audits to challenge the model validation function. Furthermore, the Internal Audit function is required to conduct an in-depth review of independent validation function of market models in order to analyse (i) its governance; (ii) its alignment to both the regulation and to the industry best practices; (iii) the perimeter of the internal models covered and their validation tools; and (iv) the methodologies and documents used.

After this review, the Internal Audit set a list of recommendations that in particular required (i) the redefinition of the internal validation functions and the model’s risk management governance; (ii) the expansion of the coverage towards a wider range of internal models, and (iii) the regularization of the validation process through a multi-year validation programme.

To address these shortcomings, the client decided to implement an effective Model Risk Management Framework on an enlarged scope of internal models, such as the valuation of financial instruments, the measurement of financial risks, stress tests, and ALM models.

APPROACH AND SOLUTION

Avantage Reply supported the bank in the implementation an action plan defined to address these recommendations through the following stages:

• To define “model”, “model risk”, and “model lifecycle” concepts.
• To identify all internal models that needed to be included in the new validation scope.
• To enhance the model risk management, the different stakeholders of each model and their roles within the model lifecycle were defined.
• A granular bank’s model inventory was designed and completed.
• In order to establish a multi-year independent validation program, a scorecard was built and used to score and rank the models taking into account the key steps of the model lifecycle of each model
• Policies, procedures, roles, responsibilities and the overall governance framework were redesigned, in line with the new scope of the validation functions and the regulation standards and the industry best practices (i.e. Supervisory Guidance on Model Risk Management – OCC, Targeted Review of Internal Models (TRIM) – ECB).

RESULTS AND BENEFITS

• The independent model validation function has been redesigned through the implementation of a Model Risk Management Framework.
• The scope of the models covered by the independent validation function was extended, from exclusively valuation models to a wider range of models including market data models, ALM models, ICAAP/ILAAP models and other more specific market models.
• The concepts of “model”, “model risk” and “model lifecycle” concepts have been defined and included in the validation process.
• A model inventory has been established and enriched with a scorecard in order to rank and tier all the models of the inventory.
• The validation process was reinforced, with the creation of both a multi-year independent validation programme and an internal audit plan, both targeting the review of all stages of a model’s lifecycle.
• Both governance and control mechanisms were enhanced, with new policies, procedures as well as an appropriate organizational structure, providing better oversight for senior management and a more active participation of the different model’s stakeholders within the model’s lifecycle.