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Perspectives

Model risk management for investment managers

Understanding the risk management model

The investment management industry is increasingly using models and complex algorithms to enhance the speed and accuracy of decision-making. Learn more about leading practices in model risk management when used in investment decisions, sales, and product distribution, business operations, and strategy.

Model risk for investment managers

Models have come into widespread use across investment management organization to facilitate critical business activities, such as algorithmic trading, asset allocation and rebalancing, liquidity risk management, and compliance, to name a few. Models drive competitive advantage and help organizations achieve operational efficiencies.

But while models can provide investment managers with valuable benefits and opportunities, not managing the organization’s use of models can pose significant risks to the organization. Model and model control failures and a lack of appropriate disclosures have resulted in significant regulatory penalties, financial losses, lost clients, or damaged reputations for investment managers.

Given the increased attention to models by investors, stakeholders, and regulators, investment managers are designing and implementing model risk management (MRM) practices to mitigate the strategic, regulatory, and operational risks to their business.

Defining model risk management

To date, there’s not a consistent, industry-wide definition for what a “model” is. As a foundation, many investment management organizations may want to consider starting with the definition of a model that’s used by banking and capital markets regulators. They may then want to tailor that definition to fit their particular business needs that more closely align with model usage within their organization. Banking and capital markets regulators define a model as being “a quantitative method, system, or approach that applies statistical, economic, financial, or mathematical theories, techniques, and assumptions to process input data into quantitative estimates.”

Within this context, “model risk” is the risk of monetary loss, harm to clients, erroneous financial statements, improper investment, or managerial decisions, or damaged reputation resulting from poorly built, used, or controlled models.

To mitigate the potential adverse impact of the model use environment, MRM is a risk management model that provides a structured approach across the model life cycle. MRM helps to define the shared roles, responsibilities, and accountabilities (inclusive of decision rights) across the three lines of defense and facilitates the development of an effective control environment, including policies, procedures, and corollary controls.

A well-defined MRM framework integrates these roles, responsibilities, and control activities and can be used to effectively mitigate the adverse risks associated with model failure.

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Understanding model risk exposures

Our experience shows that although models and complex algorithms are often associated with front-office activities such as investment decision-making, models are often used to facilitate risk management processes as well. They may be used to facilitate day-to-day business decisions.

The risk of models at many organizations may elevate the organization’s risk profile, particularly if the second lines of defense functions (e.g., compliance and risk) rely on the outputs of models that haven’t been properly developed, tested, validated, and documented.

Establishing an MRM framework and program can seem challenging at first. Familiar challenges that we have observed include model risk governance—particularly the delineation of roles, responsibilities, and accountabilities for models. This has also led many organizations to ponder the need to centralize model risk management.

Other common challenges we have observed include the degree to which the organization has an understanding of the models that currently exist and are used to facilitate decisions across the organization, the memorialization and change management practices of models, the degree of rigor with which models are challenged (particularly during the development and validation processes), and the impact and treatment of a model’s risk on upstream and downstream models and processes. In our experience, however, many investment managers already exhibit some of the basic, foundational elements of MRM.

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Investment management MRM framework considerations

MRM frameworks will be different for each investment manager. The level of effort and related costs, as well as the degree of regulatory focus, will depend on the riskiness of the investment manager’s models, model-use environment, and the regulatory environment.

There's no “one size fits all” MRM framework. Investment managers that are interested in standing up an MRM framework should include stakeholders from across the organization to discuss the underlying factors of model risk, including the nature, number, and riskiness of existing models and the existing control environment.

As a starting point, investment managers should identify and analyze their current MRM practices to identify enhancement opportunities and where they need to expand their efforts to capture all the models used throughout their business. Here are some leading industry practices that investment managers should consider when establishing or enhancing their MRM program:

  • MRM operating environment, including a complete and accurate catalog of models, risk-rated by their qualitative and quantitative factors
  • Policies and procedures with detailed guidance that governs the standardized roles, responsibilities, and activities for each stage of the model life cycle
  • Governance and oversight to manage model risk through active ownership by the senior-most levels of the organization
  • Model development and implementation with defined activities that include procedures for designing and testing the model’s underpinning theory, performance, and related inputs and assumptions, as well as documenting these considerations in a uniform manner
  • Model validation to ensure that a comprehensive MRM program has been designed and implemented effectively and that, where applicable, segregation of MRM responsibilities exist
  • Use and ongoing monitoring to identify potential model calibration or use issues in between scheduled model validations
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Now is the right time for model risk management

There’s an increasing sophistication of new models, and investment managers will need to balance the risks and returns of leveraging these new methods. Moreover, as the economic environment continues to evolve, investment managers will need to ensure that their existing “time-tested” models are calibrated, controlled, and ready for a new era.

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