Finance is a Risky Business
On May 30, 2000, Office of the Comptroller of the Currency (OCC) had issued its first guidance, OCC 2000-16, dealing with model validation and risk management. More than 10 years later in 2011, the Fed and OCC jointly issued updated and vastly expanded guidance on the topic. Though the reasons for this unusual joint effort are not entirely known, it is clear that reliance by financial institutions on mark-to-model versus mark-to-market approach has become more norm than exception. The new Fed-OCC guidance aims to disseminate best industry practices to a wider audience in hopes of making model validation activity more robust and standardized. Regulators in other regions, Asia and APAC, are also increasing efforts to mitigate this growing exposure. Yet many institutions remain woefully unprepared when it comes to model risk, regarding it as compliance more so than risk management issue.
What is Model Risk?
The definition of such rights and obliagations is the "payoff" or "payout". It is often expressed as a function or algorithm. For example, the payoff of a vanilla call option is defined as (S - K) where S is the underlying price at contract exercise time and K is the strike price.
Stages of Model Risk
Model Validation Approaches
Mitigating Model Risk
- Established standards, processes and procedures
- Updated model inventory
- People, processes and technology aligned to business needs and initiatives
- Ownership of models, processes and priorities