Abstract:
BACKGROUND : With the increasing use of complex quantitative models in applications
throughout the financial world, model risk has become a major concern. The credit crisis of
2008–2009 provoked added concern about the use of models in finance. Measuring and
managing model risk has subsequently come under scrutiny from regulators, supervisors,
banks and other financial institutions. Regulatory guidance indicates that meticulous
monitoring of all phases of model development and implementation is required to mitigate
this risk. Considerable resources must be mobilised for this purpose. The exercise must
embrace model development, assembly, implementation, validation and effective governance.
SETTING : Model validation practices are generally patchy, disparate and sometimes
contradictory, and although the Basel Accord and some regulatory authorities have attempted
to establish guiding principles, no definite set of global standards exists.
AIM : Assessing the available literature for the best validation practices.
METHODS : This comprehensive literature study provided a background to the complexities of
effective model management and focussed on model validation as a component of model risk
management.
RESULTS : We propose a coherent ‘best practice’ framework for model validation. Scorecard
tools are also presented to evaluate if the proposed best practice model validation framework
has been adequately assembled and implemented.
CONCLUSION : The proposed best practice model validation framework is designed to assist
firms in the construction of an effective, robust and fully compliant model validation programme
and comprises three principal elements: model validation governance, policy and process.
