What is model risk?

Model risk is present whenever an insufficiently accurate model is used to make decisions. Model risk can stem from using a model with bad specifications, programming or technical errors, or data or calibration errors. Model risk can be reduced with model management such as testing, governance policies, and independent review.

Should financial institutions err on the side of model risk?

If there is any doubt on the classification of a process, regulators wanted to encourage financial institutions to err on the side of “model.” With the definition of a model now in place, the regulation next defined model risk as “the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports.”

How can model risk be reduced?

Model risk can be reduced with model management such as testing, governance policies, and independent review. Model risk is considered a subset of operational risk, as model risk mostly affects the firm that creates and uses the model.

Does model risk lead to tangible losses?

In other words, model risk can lead to tangible losses for the bank and its shareholders. Regardless of where a institution is using a model in their enterprise, model risk primarily occurs for two reasons: