As last article of the Model Risk Management series, held with my colleague Spyros (here you can see his articles), I want to talk about Model Governance framework.
In the last years, widespread usage of sophisticate mathematical, statistical and deterministic models has allowed financial institutions to take strategic decisions with a new level of knowledge. At the same time, these models have led them towards additional needs: quantifying, measuring and managing Model Risk. On top of that, regulators have put an increasing pressure on financial institutions to make sure they adopt an Enterprise Framework for Model Governance. The additional requirements are rising because of the greater importance of Models Risk: financial institutions could follow incorrect decisions or make financial errors, due to the lack of a solid and well-drawn process management
Looking at the model life-cycle, it doesn't change in its phases (development, validation, deployment and audit). What changes is the "Model Governance".
Model Governance as core business function
Model Governance should ensure the alignment of the whole life-cycle model with the three lines of defense (Business Operation, Risk Management function, effectiveness and efficiency of the Model Risk). This is why it becomes one of most critical factor.
The First Line, represented by Business Operations, deals with models. It is responsible for the development of the activity and it provides their availability. The Second line, composed by Risk Management functions, is in charge for model management and validation. The model performance monitoring are executed within the second line in order to verify consistency, validity and efficacy. The third line of defense is deals with Internal Audit, that has a key role of completion of the entire Governance Picture; Internal Audit contribution consists on:
- the evaluation of the activities for the effectiveness and efficiency of the Model Risk analysis;
- the notification of deficiencies and process improvements.
The three lines of defense must be assigned to independent and separate departments in order to meet evolving regulations and to satisfy regulatory compliance.
Key elements of an efficiency Model Governance approach
Experiences achieved working with customers and the elements provided by the regulatory guidelines have granted the identification of the 8 key elements for an efficient Model Governance. The key elements can be considered as fundamental structure for a solid and valid framework of Model Governance.
Management of model risk begins from the development. The most important elements involved in the process (such as the developers that lead the components in the model definition with their experience) work here. The written documentation that describes every step of the process becomes essential for the quick and easy identification of the different correct phases.
It is consider as the core phase to test models and classify their solidity. Validation refers to the statistical methodologies used, the input/output information and the performance. From the governance perspective, some important elements to be considered, like where to find all the necessary information or when the validation material is incomplete.
Critical phases are designing, building and distributing reports to have a complete view of what is Model Governance. It is an essential element for financial institution in order to send reports to the regulators.
In a common scenario, we can find the absence or the partial presence of documentation, especially for model customization (most of the times, it is identified with an unofficial document). That practice is currently under regulator care, which requires that all the elements related to the model are quick and easy to find.
In the stage of implementation, the model is taken over and managed by several departments. The risk here is that some basic components, such as references to origin sources, model execution codes, or technical documents, can be lost. A framework that govern the overall process becomes central in order to avoid that actors involved can perform their activities without a well-identified and configured design.
Usually model retirement is undervalued or underestimated, compared to the other phases. However the performance track of models is crucial to take the best decision and to change it when it is not enough efficient.
7. Model Inventory
Model inventory is essential to obtain a big picture about what models are currently in place, which are unused, what will be used, etc... It is a synergistic view: looking everything in relation to the models from a single point of view. It allows to track every object linked to models (i.e. documentation, codes, data, etc.) as well as to identify every phase in the model life-cycle (basically, all the elements that contribute in the model risk evaluation).
8. Information sharing
In a complex process, communication becomes an essential factor for the actors involved; especially when there is a parent-child relationship of dependency in the phases. A Governance framework allows a better information sharing in terms of notification, messages, reports or documents to support and govern the entire process of model life-cycle.
A sustainable framework
Financial Institutions have to equip themselves with a sustainable, solid and valid Model Governance framework, in order to manage risk models. The Model Governance Framework allows financial institution to create a proper culture of Model Risk Management. Today it is no longer an option. Regulators request it. To learn more, watch the SAS Risk Webinar Series where our experts will present best practices based on real cases and experiences on SAS approach to be compliant with regulators requests.