The Growing Disconnect: When Boards Underestimate Model Risk
Boards are aware of model risk, at least in a formal sense. However, a growing unease among model risk executives suggests a critical gap exists between acknowledging the existence of model risk and truly understanding its implications for capital, pricing and risk appetite. This isn’t about a lack of governance; it’s about a lack of genuine comprehension of models as core decision-making tools.
The Regulatory Tightrope and the Pushback on SR 11-7
For years, the US Federal Reserve’s SR 11-7 guidance has been the touchstone for model risk management. However, the Bank Policy Institute, representing large US banks, has recently advocated for its removal. This move has sparked alarm among model risk managers within those same institutions, highlighting a fundamental tension. While banks may prioritize revenue-generating functions, some fear that diminishing regulatory scrutiny could lead to a dangerous complacency.
Beyond Compliance: The Need for a New Approach
Model risk teams are finding that simply adhering to traditional governance scripts isn’t enough to gain sustained board attention. To remain relevant, they must speak the language of efficiency, automation, scalability, and execution – priorities already top-of-mind for many boards. Demonstrating how robust model risk management can support these goals, through automated testing and streamlined governance, is crucial.
The AI Paradox: Increased Complexity, Increased Risk
Artificial intelligence offers the promise of speed and scale, but AI systems are, at their core, models – often complex and opaque ones. If model risk is treated as a secondary control function, the gap between what banks believe their models are doing and what they are actually doing could widen. This disconnect is particularly concerning in an era of rapid technological adoption and potentially easing regulatory pressure.
Culture Matters: The Role of Leadership
Risk culture isn’t uniform across the banking sector. Some institutions, like Barclays and JP Morgan, are consistently cited by practitioners as places where model risk teams feel their work is genuinely valued. This experience appears heavily influenced by the background of senior leadership. Banks with chief executives or chief risk officers comfortable with quantitative questions tend to foster a stronger risk culture.
A former model risk head noted that banks often appoint individuals from the business side as CROs, prioritizing someone who “understands us” over independent risk expertise. This approach can undermine the very purpose of risk management.
Speaking the Language of Value: How Model Risk Can Gain Traction
Model risk executives need to demonstrate how their work directly supports the bank’s strategic objectives. This means framing model risk not as an impediment to progress, but as a critical component of sound decision-making. Focusing on how good control doesn’t equate to operational drag is key. Automated testing, faster validation cycles, and streamlined governance processes can all contribute to this narrative.
The Danger of Reverse-Engineering Results
In some firms, model outputs aren’t used to inform decisions; instead, they’re treated as tools to justify pre-determined outcomes. When model outputs highlight inconvenient truths, there’s sometimes pressure on model risk teams to adjust the results until they align with desired conclusions. This “reverse-engineering” of comfort undermines the discipline that models are meant to impose.
The Importance of an Independent CRO
The selection of a Chief Risk Officer is paramount. Banks that take risk governance seriously choose CROs precisely because they are independent, possess strong views, and are willing to articulate them. This independent perspective sends a consistent message throughout the organization about the importance of risk functions.
Did you know?
Waiting for regulators to intervene before addressing material model risk problems is seen as a failure of management judgement.
FAQ
Q: What is SR 11-7?
A: SR 11-7 is the Federal Reserve’s 2011 guidance on model risk management.
Q: Why are some banks advocating for the removal of SR 11-7?
A: Some banks believe the guidance is overly burdensome and hinders their ability to innovate.
Q: How can model risk teams gain more attention from boards?
A: By framing their work in terms of efficiency, automation, and support for the bank’s strategic objectives.
Q: What is the role of the CRO in fostering a strong risk culture?
A: An independent CRO with a strong quantitative background can send a clear message about the importance of risk management throughout the organization.
Pro Tip: Focus on demonstrating how robust model risk management can enable innovation and growth, rather than simply preventing losses.
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