TRIM drives professionalising model risk management
This April, the European Central Bank will start their ‘Targeted Review of Internal Models’ (TRIM) – an indirect consequence of Basel 3.5. For financial organisations, this seems like a perfect moment to further professionalise their model risk management framework.
TRIM caused a stir. Not only because it is one of the largest, single ECB supervision operations to date, but also because organisations expect that the ECB on-sites will have significant implications for the model requirements and by consequence the capital requirements of financial institutions.
Following Basel 2 and 3, banks have been developing internal models and seeking approval from the ECB to use those models in required capital calculations. With all the effort put into developing these models, little attention was paid to the inherent risk of these models. TRIM changes this and can therefore trigger the further professionalisation of the model risk management framework.
During TRIM, the ECB will review the Pillar I models used in credit risk, market risk and counterparty risk. Financial institutions have already set up teams to anticipate the intense data requests during the short time windows of TRIM this year and next.
Most organisations already have the basics for model risk management in place with some form of model risk governance (e.g. having a first and second line of approval and a model approvement committee). However, most organisations have not considered their risk appetite when it comes to using internal models, which (inherently and avoidably) involve uncertainty. Implementing a solid framework that explicitly deals with the inherent risk that models bring to the institution, helps organisations to make decisions regarding the use of these models.
Professionalising model risk management points us towards several important areas. First, creating an overview of all the models that the institution uses is necessary, which might be more complicated than initially foreseen. Nowadays financial institutions use thousands and thousands of models and end-user computing tools. Creating an inventory of these models, including all dependencies, documentation and governance, such as model owners and users, can be a challenging task. After creating this overview, the underlying workflow or model lifecycle integrated in the framework has to be mapped. Only then it is possible to start with the analytics and reporting component of model risk management.
Proper analytics and reporting is essential. It does not only explain clearly to senior management, up to the management board, what the actual model risk is: it also puts the board and senior management in the position to make decisions regarding the institution’s model risk and their risk appetite concerning these models.
With the pressure from TRIM weighing down on banks, wouldn’t now be a good starting point to properly incorporate model risk management in decision making in the management board?
On May 30th Koen Dessens is going to speak at the Basel 3.5 Congres.
More information on Targeted Review of Internal Models?
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