What is a model risk?
Model risks occur when a financial model used in measuring quantitative information like market risks and transactions about worth poorly performs or even fails, leading to negative impacts for a company.
How models, financial institutions, and investors are interconnected
We can define a model as a system, method, or approach dependent on theories, techniques, assumptions, mathematics, statistics, economics, and many more processes data to produce an output that involves estimation of quantity. They help investors in making decisions for their businesses.
Financial institutions now use these models (hence the name financial models mentioned previously) and investors to create theories on stock price values and good trading opportunities to generate a better return and yield. These models can only pose two things: the first one is becoming a useful tool in a company or an investor, and the other option is becoming a tool for risk.
When does a model become a useful tool for a company? It is when it gives accurate investment analysis. On the other hand, it becomes a tool for risk when there is inaccurate data, errors, and output misinterpretations. If it comes to the latter part, the term model risk comes into the picture.
Explaining model risks and model risk scenarios further
As we’ve said, model risks are the results of using models with programming error, technical error, data error, calibration errors, and wrong specifications. However, there are still some ways to reduce this risk through model management that involves testing, policy governance, and independent reviews.
Most companies use the models that they’ve created themselves. If a company uses a given model, it might find the assumptions and limitations challenging to understand. In this case, the usefulness and application can become less efficient.
Model risks tend to affect a financial company’s securities valuation. A securities valuation determines an asset’s or a company’s worth or value, hence the name securities valuation. Furthermore, a model risk does not only impact financial industries; it also affects other sectors. For example, a model can have errors in predicting the possibility of having shoplifters in a mall or the probability of a few defective products in a batch of production. Why does this happen? It may be because of incorrect assumptions, program errors or technical errors, and several more factors that widen the possibility of a negative outcome.
In today’s modern age, financial models have become widely used. Before the development of these financial models, there will be a financial forecast. These forecasts will now determine future expectation results.
A model risk officer’s role in a financial institution
Some companies even hire certain people called model risk officers to create a financial model risk management program. These model risk management programs identify ways to avoid financial losses, sufferings, and problems that model risks can make. These programs have distinct components, namely: policies and governance in a model establishment. Also, different people are assigned to various roles in this program, such as developing, testing, implementing, and management.