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Financial model validation

January 16th, 2013 No comments

Increased computing capabilities, advanced modeling techniques, and commensurate increases in complexity among financial products have resulted in great reliance on mathematical models within the banking and insurance industries. These financial models are instrumental in developing robust risk management frameworks; however, the potential misuse and failures of these models can present large risks as well.

In his new paper, Jonathan Glowacki offers perspective regarding proper model validation and governance policies necessary to mitigate financial model risk.

Here is an excerpt from the paper:

Use of the model

A model validation generally starts the way you would start when building a financial model: by understanding the use of the model. This will help shape the level of detail of the model validation and allow the model validation group to focus on key areas of the model throughout the review. For example, if you are reviewing an economic model for stress tests, then it is critical that the results produced from the model are reasonable and steady in stressful environments. If the model is being used for pricing, where you are trying to develop an average cost, then the results produced by the model in extremely stressful scenarios may not be as important in the model validation. The model validation should identify the use of the model, whether the model is consistent and applicable for the intended use, and it should ensure that the model is not being used for exercises that are outside of the capabilities of the model.

Review of data

A second step of a model validation is to review the data used to develop the model. The model validation group should start with the same data that was used to develop the model. The model validation review of the data could include univariate analysis to independently identify potential variables to include in the model, a review of the range of the response being modeled (e.g., the minimum and maximum default rate in the data by calendar quarter), a review of the number and magnitude of stressful events included in the data, and more. External data not considered in the model development process could be appended to the validation dataset for a potential review of other variables that may be influential in the modeling objective that were not considered in the development stage of the model. The intent of this segment of the model validation is to understand any implications or limitations the data used to develop the model may have on the estimates produced from the model. For example, data used to develop mortgage credit models in the early 2000s generally did not include severe stress environments in the housing market. Even today, the ultimate resolution of a stressful environment is not included in mortgage data, as losses are still developing. This fact is a limitation about which users of mortgage credit risk models must be aware.

To read the entire paper, click here.