Model risk tiering: an exploration of industry practices and principles

Abstract

Model risk management continues to be an important area of risk management across financial services firms. Regulatory expectations for model risk management apply to an expanding number and variety of financial firms. In our conversations with clients, we find that many risk managers are unaware of standard practices in developing and implementing frameworks for model risk management. This paper – based on our experience as consultants, former banking supervisors and leaders of units focused on model risk management – seeks to shed light on one critical area of such frameworks: model risk tiering, or the rating of risk inherent in the use of individual models, which can benefit a firm’s resource allocation and overall risk management capabilities. Although the range of practice in model risk tiering across financial services is broad and varied, our work has revealed a number of insights.