Using Model Risk Management to Gain Strategic Advantages
If you aren’t approaching model risk management correctly, you’re putting your organization in a compromised position, because your models are being underutilized or used blindly in your decision making. An effective approach, on the other hand, gives your organization strategic advantages.
This summary statement was provided by Jeff Prelle, Managing Director of Analytics and Head of Risk Modeling at MountainView Financial Solutions, a Situs company, in a recent interview about why model risk management isn’t simply a periodic exercise involving a list of functionality checks.
While deriving strategic advantages from model risk management involves many principles, Prelle said the most basic principle is to continually evaluate a model based on its originally intended use. Over time, a business line may try to use a model for multiple functions related to its intended use. You ultimately need to look at modeling technique, regulatory scrutiny, statistical complexity and statistical validity related to the intended use; that way, your strategic advantage will come from ensuring that you’re relying on a model or modeling technique that’s well suited for the function.
Your approach to model risk management should also acknowledge that all models degrade over time, and this degradation can affect performance, according to Prelle. For example, a model implemented 10 years ago may be producing results that don’t reflect current conditions, even though your business knowledge and theory have changed significantly over 10 years. By tempering current business theory with an understanding of your model’s factors and limitations, you will know when you should re-estimate the model specification and when you should re-calibrate the model.
“Models are never going to be perfectly accurate, but you want them to be directionally correct in utilizing business knowledge,” Prelle said. “Ongoing re-calibration helps to keep models directionally correct.”
According to Atul Nepal, Assistant Vice President of Analytics at MountainView, your ongoing model risk assessments should also consider all of the data a model is built to capture and generate, and you should analyze how this data fits into the modeling framework – how it fits into the business theory behind the decisions that need to be made. The model was at one time built off of the perfect data set, and you’ve probably been cleansing all of the data as part of your model governance. But what if your data set has degraded over time? Nepal said ongoing reviews of the efficacy of your data will give you renewed confidence about your modeling.
Nepal also stated that ongoing model risk assessments should continually confirm whether your hypotheses about the outcome drivers are correct. At some point, you may realize that you’ve been mistaken about a main driver – you may realize that a factor was highly correlated but not an actual driver, and that you therefore were receiving the wrong results and making misinformed decisions. By continually confirming your hypotheses about the drivers of outcomes, you gain a strategic advantage in figuring out whether the primary connection can be tied back to your business theory.
On this point, Prelle added that the customers of a financial business are more informed every day, and this means the drivers are constantly changing, so the most important principle is that model risk should continually be re-assessed.
“You’re always trying to model behavior, and that behavior is unpredictable in a lot of cases,” said Prelle. “That’s not saying you shouldn’t try to model this behavior, but you need to be cognizant that it’s changing and unpredictable, and you need to be able to change and adapt with it. Ongoing model risk assessment helps you to constantly identify what’s changing.”
Banks Get Stress Tested. So Should Asset Managers.
In the decade since the financial crisis, the banking industry has been subjected to regular stress tests designed to prevent finance from ever again trashing the global economy. But the asset management industry has escaped similar scrutiny. That may be about to change – in Europe, at least.
Recent industry trends have heightened the need to assess the resilience of asset managers to shocks. The sheer size of the industry, as demographic trends make the pool of global savers bigger, older and richer, means assets under management are equal to about one year of total world economic output and have grown by almost 50 percent since the start of the decade.
That growth coincides with the current era of record low interest rates on government bonds, which in turn has driven fund managers to seek higher returns available from assets such as private equity, infrastructure and real estate. But funds that offer daily redemptions while owning infrequently traded assets risk-amplifying price declines when investors stampede for the exits en masse.
Read more: Bloomberg
Agencies Issue Statement Regarding the Impact of the Economic Growth, Regulatory Relief, and Consumer Protection Act
Federal banking agencies last Friday issued a statement detailing rules and associated reporting requirements that are immediately affected by the enactment of the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA).
These changes affect company-run stress testing, resolution plans, the Volcker rule, high volatility commercial real estate exposures, examination cycles, municipal obligations as high-quality liquid assets, and other provisions.
The statement from the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency describes interim positions the regulatory agencies will take before incorporating the changes into their regulations.
Read more: Federal Reserve
Singapore Central Bank Warns Trade Rows Sharply Increase Risk to Global Growth
Singapore’s central bank chief warned last Wednesday that risks to the global growth outlook have increased significantly thanks to an intensifying international trade row and the rising prospect of a rapid acceleration in inflation.
Yet Ravi Menon, managing director of the Monetary Authority of Singapore’s (MAS), also said that the baseline forecast for Singapore is for the economy to continue expanding and inflation to pick up gradually, adding the MAS “does not aim to pre-empt tail risk (least likely) scenarios”.
“Tail risks to global growth have grown significantly over the last six months,” Menon told a news conference after the release of the central bank’s annual report.
“The world has clearly moved from trade tension to trade conflict. If this escalates into a trade war, all three engines of global growth – manufacturing, trade and investment – will stall.”
Read more: Reuters
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