Internal auditing of model risk within banking institutions

Abstract

Faulty or improper usage of models has contributed significantly to financial and banking institutions’ experience of damage to their reputations and profitability. Since the global financial crisis of 2008, regulators have become increasingly concerned about the soundness of decision-making processes underpinned by, and capital requirements derived from models. Additionally, banking institutions have now recognised that flawed models are a source of significant operational risk and reliance on them can have negative consequences. Based on the importance of and increased use of models, internal audit functions should be equipped to provide assurance and auditing services to such areas within financial institutions. This research study investigates the broadening of the internal audit function’s ambit to include robust coverage of model risk within banking institutions. A brief literature review on model risk within banking institutions is followed by an investigation into internal auditing expectations and requirements regarding the coverage of model risk. The quantitative research which was performed is described, and conclusions drawn as to the state of risk management, internal audit’s coverage and the skills needed to effectively assess model risk. In addition, the degree to which these have become embedded in these organisations is assessed. The research paper concludes with a set of recommendations on how internal