FCG conclusions on the importance of an independent model validation
A changing and complex regulatory environment is the new normal for banks. During the past couple of years banks using the internal ratings-based approach (IRB) for calculating their capital requirements for credit risk have had to re-develop their IRB models to comply with the new definition of default and the new guidelines from EBA. Advisense has supported the majority of the Nordic banks developing new IRB models in accordance with the new guidelines. The next natural step after a successful model implementation is to establish an effective validation process to ensure accurate, consistent and unbiased predictive estimates.
Banks using internal models must align with Article 174(d) of the Regulation (EU) nr 575/2013 (CRR): “the institution shall have a regular cycle of model validation that includes monitoring of model performance and stability; review of model specification; and testing of model outputs against outcomes”. The importance of having a sound process for model validation is clear, a biased credit risk model leads to incorrect measurement and assessment of credit risk resulting in miscalculation of the bank’s capital requirements.
The life cycle of model risk parameters must include an independent validation of the internal models, to allow for an objective assessment of the rating systems. Impartiality is essential to prevent possible disguise of the model deficiencies and weaknesses. Furthermore, having an independent fresh view on the rating systems, by people not involved in the development process, fulfills the purpose of a sound model validation and enable to find improvement possibilities of the models.
In practice the independence of the validation function requires, as a minimum, for smaller institutions that the staff performing the model validation should be separate from the staff responsible for model design or development. Larger institutions, with more complex operations, must have a separate validation unit with adequate independent reporting lines. The independence of the validation is not only restricted to IRB models, it is also a requirement for other internal models, such as IFRS 9, AML, etc.
When collaborating with FCG as a third-party service provider, it is possible for an institution to achieve true independence easing the communication towards internal stakeholders, competent authorities and aligning model risk management practices to meet risk appetite and expectations.
In summary, an independent model validation process is required from the regulator for banks to ensure:
- accurate, consistent and unbiased predictive estimates
- to find possible model deficiencies and weaknesses
- that the models are acceptable for business users
- that model assumptions are in line with economic expectations
- a high-quality rating system
Moreover, by ensuring an independent validation the bank will also ensure that too conservative estimates are challenged. It is important to acknowledge that the validation exercise is not only a requirement from regulators and auditors. The accuracy of models may improve the financial steering and profitability of the bank. An adequate validation process may be decisive for the strategic portfolio allocation and product strategy.
FCG is advising multiple banks across Nordics and also have internal methodological committees around credit risk modelling and validation, where the skills, competences and operational conduct provided by FCG will align to best practice which can be shared on individual requests from clients. Hence the validation will not only be the yearly tick-off exercise, it will provide a model benchmark against best practice within the risk modelling world and will give a unique possibility to improve the models.
Please contact René or Johan if you would like to know more:
