Risk Management & Analytics: Shifting the Mindset About Financial Model Validations

Shifting the Mindset About Financial Model Validations

At banking organizations, financial model validations can be simply viewed as a necessary task on a checklist for following regulatory guidance. Some institutions also believe that the quality of a model validation is less important when the institution or business line is successful and when local, regional and national economies are all thriving.

At moments like this, the model risk management consultants at MountainView Financial Solutions, a Situs company, remind institutions that periodic model validations are not just tasks for “identifying potential limitations,” as stated in one sentence of Statement SR 11-7 from the Federal Reserve. While periodic reviews are mandated, MountainView believes that financial model validations should be more than simply complying with regulations and managing risk; instead, they can be an opportunity to improve performance.

While all regions of the United States are currently experiencing economic prosperity, SR 11-7 points out that model validations can be more critical now than at other times. “Validation is an important check during periods of benign economic and financial conditions, when estimates of risk and potential loss can become overly optimistic and the data at hand may not fully reflect more stressed conditions,” according to the statement.

MountainView has seen more banks and credit unions embrace these two philosophies, as the number of model validations the company provides continues to increase annually. Performance improvement – and the strategic decision-making confidence that comes from it – has also been a driving factor in the increasing number of validation requests MountainView has received for non-traditional models such as mortgage servicing rights, mortgage pipeline, funds transfer pricing, and Allowance for Loan and Lease Losses, to name a few, according to Christine Mills, Managing Director and Head of Model Validations at MountainView.

MountainView’s independent model validations follow SR 11-7 guidance by including a conceptual soundness review, ongoing model monitoring, model performance testing, outcomes analysis, and a review of the model governance solution. Consistent with the evolving perception of validations improving performance and not just being mandated, MountainView’s clients are also increasingly seeking to align with preferred modeling practices.

Offering an example of this request, Mills says, “Our clients are interested in knowing how their assumptions and policy limits compare to their peers, and this is provided in our validations as a benchmarking of their results to their peers.”

Mills adds that this is only one example of how perceptions are evolving across the banking industry. “Whether it’s the advent of fintech or something else, we’ve been seeing less of a ‘check the box’ mindset about the necessity, quality and frequency of model validations.”

Federal Reserve Sets Dates for Public Release of 2018 Stress Test Results

The Federal Reserve has announced the schedule for the release of its 2018 stress test results, with the Dodd-Frank Act Stress Test (DFAST) results set to be unveiled on June 21 and the Comprehensive Capital Analysis and Review (CCAR) stress tests results to be released on June 28.

It’s been clear that the central bank would issue the stress test results by the end of June, but the specific dates of the releases are generally not announced until a few weeks before that deadline.

DFAST and CCAR are among the most important supervisory tools the Fed uses to examine banks. Federal Reserve chairman Jerome Powell called stress testing among the most important post-crisis innovations.

But the agency has suggested some changes to the stress testing regime.

Read more: American Banker

Why Choosing the Right Loss Rate Methodologies Is the Largest CECL Concern

A recent poll of bank and credit union managers and executives were asked what their largest concern is in 2018 regarding the accounting standard transition from the incurred loss to the current expected credit loss (CECL) model.

Sixty percent of respondents said finding the right methodologies to use when calculating their allowance is currently their largest concern regarding the transition.

Given that the CECL model is non-prescriptive, credit unions have flexibility in choosing the right methodology for their institution’s unique data situation. This flexibility, combined with the fact that calculating an appropriate blend of methodologies is itself a daunting task given all the variables, often leads bankers to one simple question: Where do I begin?

Read more: Credit Union Times

Fitch: Structured Finance Faces LIBOR Coordination Risk

Stronger provisions in transaction documentation ahead of LIBOR’s discontinuation are an important step to limit the number of legacy structured finance (SF) contracts, Fitch Ratings says. However, much still needs to be done before the end of 2021 when forced LIBOR panel participation will end.

Fitch has reviewed new template language from trade associations and LIBOR phase-out wording in recently closed SF transactions. A new benchmark rate concept is being added along with the process to change it; noteholders are only being asked to participate actively if they disagree with the change. Template language from the Association for Financial Markets in Europe also introduces a possible adjustment to the effective margin paid to noteholders, which Fitch expects will be necessary since risk free rates (RFRs), which do not include an element of bank risk, should trade at levels below LIBOR.

The widespread adoption of language addressing LIBOR discontinuation is important, because transactions have continued to reference LIBOR despite the upcoming changes. However, the added language does not yet provide certainty on how a change to a new benchmark rate would occur in practice, because the final replacement rate, and how discrepancies between it and LIBOR will be addressed, are not yet known.

Read more: Fitch

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