A regular assessment of models is conducted and a model weakness inventory is created. Together with a complexity and materiality scoring of the model portfolios, a risk/materiality matrix is defined that enables identification of portfolios for subsequent in-depth validation.
A thorough model validation is conducted and all relevant model issues and validation results are presented in a validation report. The validation report is presented along with corrective actions recommendations to the model risk committee to come to decisions. The model risk committee will act according to the weakness management process with definition of follow up actions such as restrictions in model use or prudent adjustments.
Examples of end-to-end Validation Exercises
Involves performing back testing on lower portfolio levels for a long period of time, dividing back testing results into risk drivers. This is done for different quadrants based on dirty P&L along with clean P&L.
VaR and P&L Consistency Tests
Understand the pricing model weaknesses and their implication for VaR, verify consistency of P&L and VaR calculation processes and analyze inconsistencies.
Risk Measure Consistency Tests
Risk measure consistency tests investigate relationship between stress tests and VaR as well as stressed VaR and VaR and comparing different VaR percentiles.
Independent Plausibility Checks
Conduct alternative VaR calculation on different pricing model and sensitivities. Compare alternative VaR models: covariance matrix, simulation etc.
Contents of Validation Report
To understand the impact of the model validation on the organization, the validation report has to be communicated effectively and in a transparent manner to the management as well as other stakeholders . Some examples include:
- Goal: Management’s understanding of the weaknesses and limitations of the market risk model and its consideration of appropriate actions
- Conclusions: Validation conclusions with transparent explanation of consequences for the bank’s business and necessary action.
- Follow-up: Recommendation for follow-up actions, model improvements, mitigating measures etc.
- Addresses: Bank’s management, model users (controllers, front office), auditors
- Form: Management presentation understandable also for non-quantitative analyst
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