Is model risk management the future of financial services?

A multitude of factors and stakeholders generate new demand for financial service operational risk management. Increased data availability, breakthrough technology, innovative value chains and business models continue to transform how banks engage with customers, interact with third parties and communicate internally. Operational risk must, therefore, be mitigated in a dynamic environment and the continuously evolving risk landscape.

First, traditional controls and processes need to be updated. Banks could also look at this need to evolve as an opportunity for improvement. New technology adoption and new data are key to improving model risk management (MRM) for financial services so the targeted MRM framework performs with higher efficiency and is better integrated with decision-making processes.

The current state of MRM services for financial services:

Operational risk management became a separate domain just two decades ago. Banks understand the risks that come with employee and operational activities. However, in multiple publications from 1999 to 2001, the Basel Committee on Banking Supervision (BCBS) elevated operational risks to a controllable and independent risk category that needed unique organisation and tools.

Within the first 10 years of active MRM development, banks and financial companies focused on governance, establishing foundational elements such as reporting loss events, risk-control self-assessments (RCSAs) and operational risk capital model development. With the economic crisis came a new wave of compliance and regulatory actions and fines on questionable practices in mortgage foreclosure, mis-selling, financial crimes, foreign-exchange misconduct, the London Interbank Offered Rate (LIBOR) and fixing. Each event highlighted vulnerabilities, with previous risk management practices entering the banking system. In response, financial organisations increased their investments and focused on operational risk capabilities. They created risk taxonomies not limited to the BCBS-defined categories, established new risk assessment and identification processes, and built extensive controls and testing processes.

Meanwhile, other challenges to operational risk management have continued to grow. The diversity and volume of risk types have grown while operational complexity is much higher. Specialised risk categories are more clearly defined now, such as third-party risk, unauthorised trading, misconduct, unethical sales practices, cyber risk, operational resilience and new-product risk.

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Five features essential for MRM technology:

Incorporating several available features can empower financial organisations to address the challenges of today’s risk management processes.

1. Support for the complete lifecycle of the model and stakeholder involvement:

Financial institutions should ensure MRM technology is effective in tracking models in every stage ofthe lifecycle while following internal governance workflows for versioning, approvals, validation, documentation, finding management, and stakeholder involvement and communication.

2. 360-degree view of the model and a model universe:

It no longer suffices to have a static list of models. Every financial institution must regularly update its model inventory and be able to react quickly to any changes in a model, its elements or a group of models.

3. Model risk quantification and MRM insights:

Financial institutions must be able to analyse over a thousand data points using a mix of qualitative and quantitative data, ensuring greater insights on the company’s model risk concentrations.

The future of MRM services for financial service providers:

At the global level, greater analytical model governance has become essential to meet the changing demands of business decision makers and regulatory bodies that need to be aware of the different models that support business decisions. Regular updates to regulations governing model quality ensure more enterprises invest in this domain. For instance, the European Central Bank’s (ECB’s) new model-quality review process in Europe is effective for the next four years and will cover the internal models of every bank the ECB supervises. Banks whose model validation or model development and monitoring environments do not comply with the guidelines and are not updated would have to invest in the necessary improvements.

Financial institutions must focus on current needs and plan well for the future. They need to employ strategic thinking and prepare for possible new requirements and behaviour trends while ensuring efficiencies on both the business and compliance sides. Banks and NBFCs need to use adaptable and flexible MRM services and systems that can meet the changing demands of external and internal MRM stakeholders.

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