Audit of Market Model Validation function

Avantage Reply was engaged to provide subject matter expertise to the internal audit of the client’s market model validation department. This included the audit of all potential aspects and gaps to a comprehensive model risk management framework, notably the audit of the governance, organisation, policy, methodology and supporting documentation.

The client

The client is a public development bank, active in the field of financing to the local public sector and the refinancing of major export credit agreements. Its main aims are to enable local governments and public hospitals to benefit from enhanced financing conditions, and to improve exports through the refinancing of large export credits.

The challenge

The client needed to conduct an audit of its market model validation division. Avantage Reply was engaged to assist the internal audit team, to provide a subject matter expert and insight on industry best practices, as well as model risk regulations on the matter. Model risk management expectations have grown both in the US, where model risk regulation has been established since 2011 with the Supervisory Guidance on Model Risk Management (SR Letter 11-7), and in the EU, with the ECB’s increasing focus on model risk governance as part of SREP and TRIM.

Approach and solution

Avantage Reply followed a rigorous audit process using a typical audit risk-based approach. It facilitated several discussions and workshops with the senior management, and the model validation team to identify the critical points within the actual Model Risk framework, analysing the gaps with current regulatory constraints and market practices. The audit encompassed notably the below stages:

• Clarification of the governance framework, analysing the risk management framework, roles and responsibilities, and perimeter covered.
• Review of the technical validation methodology (theoretical and operational validation) with a focus on model lifecycle characteristics.
• Analysis of the independence and quality of tools, and a review of documentation.

Results and benefits

The audit exercise demonstrated the need for various improvements within the market model validation function and particularly enhanced the client’s awareness of model risk management. Notably, the main client changes expected following the audit are:

• The scope of the policy should be extended, from exclusive valuation models to a larger scope of models including notably risk dedicated models.
• Governance should be adjusted with more involvement of senior management in the decision process.
• The level of model risk within the Bank should be monitored through a model scorecard and inventory. This would enable comprehensive Model Risk Reporting to senior