Model Risk – Overview, Sources, and MRM Framework

Model risk management services

Today, understanding model risk management (MRM) is essential for financial institutions. With a good MRM framework, every enterprise can predict any possible shortcomings and mitigate risks on time.

Model risk is the potential loss an institution could face based on various decisions within a model. Risks usually result from errors in development, implementation, or use. If not combated within the model’s framework, risks can have devastating financial implications for companies. Therefore, model risk management (MRM) services are very important today.

Risks arise for two main reasons:

  • Fundamental inaccuracies
  • Incorrect or inappropriate usage

When encountering risks, determining their source is usually the best way of combating them. MRM services help find the source of the risk, eliminating any possible weak link in the process.

Sources of Model Risk

Some of the main sources of model risk include the following factors:

  • Inaccurate, distorted or incomplete data
  • Incorrect or incomplete model implementation, creating false results
  • Errors in the statistical methodologies
  • Unrealistic assumptions creating incorrect parameters, making the model impractical
  • Inappropriate model use
  • Data misinterpretations
  • Incomplete or inaccurate model inventories

The only way to combat model risk is through a good MRM framework. Many expert-led model risk management services today provide comprehensive frameworks that promise effective risk management.

Building a Model Risk Management (MRM) Framework

The SR 11-7, introduced by the US Federal Reserve in 2011, standardised MRM processes worldwide. The document ensures industry-wide practices that optimised MRM frameworks while assuring model efficacy.

An ideal MRM framework follows these crucial processes:

Following Standards

Before development begins, standards and guidelines need to be set in place that account for:

  • Data quality
  • Model changes
  • Expert opinions
  • Methodology
  • Validation
  • Documentation
  • External data
  • Reporting

Modellers can also include any other parameters they deem necessary while setting this foundation.

Risk Appetite

The risk appetite is how much risk the organisation is prepared for to meet its objectives. The appetite usually depends on the model’s purpose and usually involves metrics like aggregate quantitative risk exposure, how many high-risk models exist etc.

Risk Identification

Identifying specific risks using a model inventory helps organisations understand the nature of risks and any key model changes. The inventory usually categorises models by name, purpose, usage, usage frequency, and assumptions.

Assessing and Measuring

You can scale quantitative and qualitative risk assessments of each model to an enterprise-wide risk assessment framework. Sensitivity analysis, back-testing, and challenger models are common methods to quantify risks. Qualitative assessments determine if the model is fit for its purpose.

Risk Mitigation

Once you have the previously mentioned factors in place, mitigating the risk becomes easier. You can alter development, add validation, employ external judges, etc., to understand precisely how to strengthen your model.

Monitoring and Reporting

Finally, you need to ensure you adhere to the model policy and appetite. Monitoring with regular MRM reports reveals any need for management intervention. Model risk management services usually include providing a checklist for more effective monitoring and reporting.

Therefore, organisations can easily keep model risks at bay with the right developers by predicting and mitigating them. This way, they stave off any potential financial losses and maintain their profit-loss balance effectively.