Banks and asset managers cannot offer services to any individual/business without analysing the risks involved. Besides customer-related risks, financial institutions face many market-related risks. They need to manage these challenges to maintain their return on investment. Amid the pandemic, many financial institutions failed to maintain business continuity, as they failed to understand the market disruptions and had not prepared to handle them. A number of financial risks could also impede the functioning of banks and other financial institutions.
To identify these risks in advance, financial institutions rely on financial models. For example, a bank may use a financial model to monitor customer transactions. Sometimes, though, the model may not work as intended. This requires maintaining the models’ consistency and efficiency, and explains why financial institutions invest heavily in model risk management services.
Aspects of sustainable enterprise model risk management
1. Developing a standard risk management programme
The first step is to create a standard programme for model risk management across the organisation. The different departments should use the same model risk management framework. The steps for creating a new model should be the same, so as to ensure consistency in model risk management across the organisation.
2. Maintaining a model inventory
Banks should compile an inventory of all the models used and update this periodically. This would provide a centralised location of information regarding the models.
3. Proactive model monitoring
Financial institutions do not have to wait for a model to fail. Crucial financial models should not break down, as this would impede business continuity. With proactive monitoring, banks would know before a financial model fails. New-age software solutions would help financial institutions proactively monitor the models.
4. Validating models
Model risk management services should focus primarily on model validation. Model validation confirms the model achieves what it was built for. Model simulations could be used to compare against model validation activities.
5. Presenting real challenges
Financial institutions should present financial models with real-world challenges in an internally controlled environment. Such tests help the financial model evolve and the institution to determine shortcomings, if any.
6. Governing model risk factors
Several factors could hamper the continuity of a financial model. For example, if a model is inconsistent across the transaction lifecycle, it will not provide accurate results. Therefore, the structure, consistency and robustness of financial models should be monitored at all times.
7. Outsourcing model risk management
For the best results, banks could outsource their model risk management activities, saving on in-house resources and overhead costs.