What is Model Risk Management, and why its important?
The financial community has long used models to assess, manage, and price various tasks. As the use of automation and technology increases, statistical techniques become sophisticated, and data sets grow, making mathematical, economic, and statistical tools more central to a financial institution’s operations. In many cases, they build model systems by using different models’ outputs to benefit the financial firms.
That said, misuse or failure of models may cause severe damage to a firm’s reputation, solvency, and finances. That is why many financial firms hire model risk management services to look closely at their models and ensure they benefit the firm as expected.
Understanding Model Risk Management
Model risk management means assessing risks from a decision’s adverse consequences resulting from misused or incorrect models. It aims to employ practices and techniques that measure, identify, and minimize model risks associated with illegal or erroneous model usage. In the financial sector, model risk refers to loss due to using inaccurate models while making decisions, evaluating financial securities, assigning credit scores, predicting profitability, and money laundering.
Financial institutions primarily rely on market, behavioral, and credit models to manage risk and improve operational efficiency. These firms mainly earn money by taking risks. Therefore, they need well-built models to measure risks, understand consumer behavior, manage data, make investments, and assess compliance. Implementing effective model risk management services is essential for organizations relying heavily on quantitative models for decision-making and operations.
Significance of Model Risk Management
Models are critical to a financial institution’s success. Fundamental errors in the models can lead to adverse consequences resulting from erroneous inputs, unauthorized model changes or usage, incorrect assumptions, or model usage outside of its intended purpose. Unfavorable consequences may include underpriced risk, ill-formed underwriting, misguided strategies for asset diversification, false market liquidity assumptions, compliance issues, operational gridlock, and loss of market and institutional knowledge.
Model risk management mitigates various model risks by shifting focus to the right models to use. Risk modeling effectively identifies, analyzes, and mitigates risks, allowing the firm to stay prepared for them as they occur. Here are a few reasons why model risk management is an essential step:
Risk Identification: Instead of going into a project blindly, one must identify the risks involved. Identifying the risk is a continuous process that distinguishes positive and negative events throughout a project’s life cycle. Building a risk register lays all the potential scenarios in a clear vision, ensuring the firm is aware and prepared to tackle them.
Better Communication: Free-flowing, honest communication between parties, is critical to a project’s success. Each team member must stay updated about the risks during different phases of the project. Remember, efficient risk management is not limited to understanding, testing, and modeling; it extends to communicating with the team members.
Clear Assignment of Responsibilities: Model risk management boosts an institution’s risk maturity, failing which positions it at the bottom. Having a well-established model risk management system in place sets a business apart. It helps define clear roles and responsibilities for team members during different risk modeling phases.
Effective model risk management services improve an organization’s chances of delivering projects on budget and on time. This is because once it assesses the risks involved, it can make project estimates more accurately. Having foresight of risks allows a business to stay prepared, avoid overruns, and be honest to its stakeholders.