Introduction

The various models utilised by the financial sector for monitoring risk exposures and valuating products have been heavily criticised by industry commentators over the last 12 months. Much blame has been apportioned to model risk, in particular VaR and its failures being cited as a factor in the demise of the global economy.

Key findings

• Current Practices – None of the banks interviewed for the research had a fundamental definition of model risk management but had a form of management or governance process to oversee model accurancy through validation.
• Benefits of Model usage –  There are many perceived benefits associated with the use of models throughout the financial industry. These advantages have been heightened by continuous technological advances.
• Criticism and drawbacks – There has been much criticism of the various models used by financial institutions of late, with much of this negative attention being focused on misinterpretation and blind reliance on model output.
• Vetting and Validation methods – Models will not be abandoned because of past failures and will continue to play a significant role in the foreseeable future. Therefore, for maximum effectiveness to be derived, there needs to be a process under which new models are vetted extensively and existing models are continuously validated.
• Future Initiatives – In view of the criticism directed at ineffective models, Lepus wanted to find out if banks were responding to this through greater investment in regards to model risk management. The responses suggest that much of the criticism is unjustified and that the players of the financial industry are ultimately confident in the abilities of these models.

Conclusion

Risk management is both a science and an art. Theoretical models will always play a vital role in risk management. However, for models to be effective they must be used carefully and in conjuction with risk managers’ own judgement. This will ensure that each model is used in the right situation and that it remains accurate to changes in the financial climate. Models have shown themselves to be vulnerable when relied upon too highly and effort is not made to fully understand the associated outputs.

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