Methods and Processes for Effective Model Validation

Sept. 26, 2012 - PRLog -- Errors in financial models that banks use on a daily basis could lead to tremendous financial and non-financial losses. It is crucial for banks to understand how they could minimize and manage model risk effectively. In addition, the OCC and the Federal Reserve have recently released new guidelines on model risk management, which will significantly modify their existing model risk management practices.

Antton Barandiaran answered a series of questions written by GFMI before the forthcoming Model Risk Conference, December 3-5, 2012 in New York, NY. Antton shares his thoughts on model risk strategies.

Antton Barandiaran Vice President of Model Validation at Santander U.S. Mr. Barandiaran participated in the start-up of the model validation department, which covers the models developed and used in Sovereign Bank, Santander Puerto Rico and Santander Consumer U.S.A. Previous to working at Santander U.S, he worked as a Senior Quantitative Analyst at Banco Santander.

1. How are the new guidelines released by the Fed and the OCC (Letter 11-7) going to impact model validation practices?

Antton Barandiaran: The OCC has been enforcing the guidelines in OCC 2000-16 over the past decade and the new bulletin incorporates the experience acquired. The new guidelines augment the scope of Model Risk Management (MRM) by including requirements for model development, implementation and use. The guidelines place a special emphasis on documentation, and their implementation should contribute to a better understanding of models by users, senior management, validators, supervisors and other stakeholders. This in itself should result in a decrease of model risk; for example by reducing the likelihood of implementation errors, or of misinterpretation or misuse of results.

The new guidelines also broaden the scope of MRM by including model-related governance and controls, with the aim of increasing the effectiveness of the different components of MRM. Additionally, the OCC requires the creation and the maintenance of an inventory of the models in use. I believe this is an important tool to enhance the comprehensiveness in model risk identification, measurement, and management.

2. Why is it so important to have independent in-house validation teams?

AB: Model validation and model risk measurement are regulatory requirements. They can improve the models, as well as the quality of the decisions that are based on their output. Both validation and model risk measurement should be performed on an ongoing basis, as changes in economic or market conditions can impact model performance. The cost of outsourcing a periodic validation process for the set of material models used in a bank will in general be higher than allocating budget and human capital for an in-house validation team.

3. Many banks actively use consultancies and external auditors for model validation today. What are the potential problems with this?

AB: Model validation should be performed by a team with appropriate incentives, competence and influence, which may be hard to obtain when outsourcing. If external auditors or consultancies are to be used, I believe that they should be hired outside the model development function to avoid conflicts of interest, and thereby increase the credibility of the validation’s results to users and regulators. As mentioned in a previous response, validation should be an ongoing process; one that may be hard (or costly) to maintain when it is assigned to a third party. Additionally, database and system specificities may make it time-consuming to acquire the baseline knowledge required to produce a validation.

On the other hand, the use of external resources can bring added knowledge. For example, some consultancies have acquired a great deal of experience in meeting regulatory expectations and they have access to extensive industry information for benchmarking.

4. What do you think participants would gain from this event?

AB: I hope that this event will serve to increase understanding of how professionals from a diversified sample of organizations in the financial sector manage model risk. Through case studies and presentations, attendees will learn how different institutions meet the challenges of implementing a MRM framework and making it work.

For more information please contact Michele Westergaard, Senior Marketing Manager, Media & PR, marcus evans at 312-540-3000 ext. 6625 or Michelew@marcusevansch.com.

About the Model Risk 2012

This unique event will take place in New York, NY from December 3-5, 2012. Industry leaders attending this event will benefit from a dynamic presentation format consisting of workshops, panel discussions and case studies. Attendees will experience highly interactive conference sessions, 10-15 minutes of Q&A time after each presentation, 4+ hours of networking and exclusive online access to materials post-event.

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