Broader application of risk models in business practice and increased sophistication of modelling techniques leads to new risk management challenges. Very simply put, how do we know that our risk models are reliable and work as intended? Model validation is at least as important as the model development process itself. However it is also one of the most overlooked. Model inaccuracy, misspecification and ineffectiveness can have negative implications on risk measurement and, consequently, on financial performance and reputation of a bank. Risk model errors can lead to inefficient pricing of risk, deterioration of asset quality, as well as an inappropriate capital base due to unexpected losses and inadequate provisioning. Thus, to assure soundness and reliability of models in use, financial institutions should increase their attention and allocate more resources to model validation activities. An important benefit of these activities also relates to the spectrum of models in use. A validation process can advocate the application of several models instead of only one and provide comparison of the results and their robustness in each case.
The increased importance of model validation has been emphasized by regulators. Assessing and testing model validation processes has become the central component in supervisory examinations of financial institutions. In a nutshell, in today’s environment of high reliance on models for market, credit and operational risks, well managed model risk is becoming a source of competitive advantage for players in the financial industry.