Risk Management & Analytics: Blind spots are the biggest risk in financial modeling

Blind spots are the biggest risk in financial modeling

What happens if right after you finalize your financial models and get ready to make critical pricing or balance sheet decisions, your head of risk modeling leaves your institution with little notice, and to your dismay, little documentation? While your former model developer was brilliant, your institution is now left with a range of financial models that may or may not be accurate or effective.

“While this scenario may seem rare or unlikely, it isn’t a scenario you want to face,” says Ray Wong, Vice President, Analytics at MountainView Financial Solutions, a Situs Company.

But identifying unlikely circumstances or hidden risks is exactly what Wong’s job entails. In fact, Wong spends much of his time combing through and analyzing modeling assumptions, data, processes, documentation and governance to protect businesses from the thing that tends to get the best of them every time: blind spots.

“When reviewing a model, it’s not always that a model is incorrect,” states Wong as he shows a graph of model validation results. “It is just that specific aspects of a model, model process or modeling data may be inaccurate, or details — such as product contractual characteristics — may be overlooked. And unfortunately, the outcome of a flawed model can, at first glance, appear picture-perfect.”

Wong’s graphs reinforce his point. The first graph of a Mortgage Servicing Rights (MSR) portfolio prepayment back-test analysis appears somewhat in line and directionally correct at first glance. However, when he shares the validation results, it is clear that he found a glaring error: The original model assumed that 5/1 ARMs prepay at speeds that were typical of the MSR portfolio as a whole (which were dominated by 30-year fixed-rate mortgages), when the ARMs typically exhibit vastly different prepayment behavior. The implications of this could result in skewed forecasted prepayment speeds, which could affect the valuation of the asset, and potentially, balance sheet accuracy.

In further discussing the importance of model validation, Wong points out that bank and credit union regulators require independent validation of financial models. However, from Wong’s point of view, regulation should not be the primary reason for an institution to obtain a third-party validation. An organization should want to ensure its models and model processes behave as expected since they inform significant business and balance sheet decisions. And, says Wong, the same is true for an institution’s trusted resources. If the brilliant model developer ghosts the institution, it will spend precious days trying to develop and document new models from scratch. A validation can highlight the larger blind spots as well as the more nuanced.

Wong warns, “Risk exists in the people, process and technology.”

If your institution requires a financial model validation, please reach out to inquiries@mviewfs.com

Federal Reserve proposal would expand regulatory gap between GSIB, regional banks

Recently proposed changes to how regulatory capital and liquidity is managed and reported at U.S. large regional banks continues the bifurcation of regulatory relief between Global Systemically Important Banks (GSIBs) and smaller peers, says Fitch Ratings.

Generally, the proposed relaxation of regulatory and capital standards is a negative for creditors at U.S. large regional banks, especially the potential loss of the comparability of annual public stress tests. However, Fitch does not anticipate ratings changes directly as a result of the proposed changes, with the ultimate ratings impact dependent on how banks respond to, and operate under, more relaxed regulatory requirements.

“We expect banks to most likely proceed with caution in decommissioning stress testing and related elements, such as resolution planning, especially given the potential for changes in the political and regulatory environment in the future. We expect highly-rated banks to continue to exercise disciplined capital and liquidity risk management,” the analysts wrote.

Read more: ABL Advisor

Federal Reserve revises supervisory rating system for large banks

The Federal Reserve Board unanimously voted last week to finalize changes to its supervisory ratings system to better reflect the agency’s post-crisis emphasis on bank capitalization, liquidity and governance.

The final rule eliminates the so-called RFI ratings system, which the Federal Reserve has used to assess banks’ safety and soundness since 2004. The RFI system focuses on risk management, financial condition and the impact of a firm’s non-depository activities on its depository subsidiaries.

But the central bank will now use a “large financial institution” — or LFI — ratings system, which parallels a supervisory program the central bank established in 2012 to emphasize capital, liquidity, and governance and controls. In the wake of the financial crisis, the Federal Reserve began to apply new attention to other aspects of bank safety and soundness, particularly with respect to the role that liquidity plays in in bank solvency.

The Federal Reserve said in a press release that the final rule simply conforms what had been an outdated ratings system to the newer supervisory program, which “is aligned with the core areas most important to supporting a large firm’s safety and soundness and U.S. financial stability.”

Read more: American Banker

Small banks join forces to address fintech challenges

A dozen community banks have formed a group to explore fintech opportunities.

Alloy Labs Alliance is managed by the consulting group FinTech Forge. While the alliance is in its early stages, Alloy’s members are optimistic that they can leverage their combined resources to meet small banks’ technology needs.

The alliance, which provides a platform for banks to share ideas and best practices, includes Citizens Bank of Edmond in Oklahoma, Reading Cooperative Bank in Massachusetts, NBKC Bank in Kansas and CenterState Banks in Florida.

Other industry groups have recently announced efforts to promote small-bank collaboration and innovation. The Independent Community Bankers of America, in conjunction with the Venture Center, launched a community bank-focused fintech accelerator program in Little Rock, Ark.

Read more: American Banker

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