Establishing a positive model risk culture — the first core element of robust Model Risk Management

Written by Lucy Worsley

Model risk is more important than it’s ever been. To respond to these growing demands, successful identification, assessment, control and mitigation now needs to be a core part of a financial organisation’s DNA.

Taking steps to achieve this will extend far beyond simple regulatory compliance. It will enable cross-organisational regulatory compliance and embed principles that are embraced and understood by key decision makers in your business.

We’ve already spoken about the three core elements every bank needs to get right if they want to manage model risks successfully. In this blog, we’ll take a closer look at the first of those elements: establishing a positive model risk culture.

Or, if you’re ready for the next steps, you can read our in-depth blogs on leveraging controlled innovation and improving MRM efficiency.

And remember, for more in-depth insights, you can always download our specialist Model Risk Management Guide. Learn more about the guide from this link, or read it straight away by clicking here.

What is a positive model risk culture?

Establishing a positive model risk culture across your firm means ensuring everyone has an  understanding and awareness of model risk. Reaching far beyond risk-based model owners, developers and validators, this includes the users of models, the board and senior committees making decisions. Ultimately, better awareness across all these different areas enables clear model identification and application of MRM principles.

For example, the limitations and operating boundaries of a stress testing model are fundamental to any decisions relating to an Internal Capital Adequacy Assessment Process (ICAAP) exercise. Similarly, the correct and complete imputation of inputs within a corporate rating model can have pricing, expected and unexpected loss implications. It’s clear that all model risk stakeholders should know what constitutes a model, the potential risks associated with them, and the benefits of managing them appropriately.

Why is a positive model risk culture so important?

A single model rarely operates in isolation, and they often form extensive networks of interdependencies and linked validation actions contributing to a variety of decisions. For instance, a change to credit history data collected at application could feed into strategy, stress testing and model risk appetite.

When key stakeholders aren’t aware of this bigger picture, it can lead to unintended model risk consequences. A topical example of this would be newly introduced Generative AI tools being implemented for business purposes in areas of the organisation new to model risk management. These are new and evolving techniques in an area potentially not familiar with model risk, which could lead to poor customer decisions and outcomes — potentially resulting in fines and reputational damage.

Culture change is directly linked to the priorities set by the board and senior management; individuals will focus their attention where the resources are allocated. That means you can’t expect any behaviours to change unless your board is committed to driving a principle-based, model risk-centric culture.

What happens if this positive model risk culture is missing?

Model risk can have serious implications.

For example, let’s say a process efficiency is made by using a Generative AI System to compose responses to complaints letters. As a process tool, it could be considered out of scope of MRM principles, so it’s quickly implemented within the business. A customer soon receives an incorrect and inaccurate response, and shares it on social media. The post goes viral.

Alternatively, consider a hardcoded implementation of a PD calibration within a pricing model. In this instance, the PD calibration is updated but the pricing model is not. Customers are no longer being treated fairly, with pricing based on out-dated, inaccurate models.

A positive model risk culture would have ensured model risk management principles were followed. The Generative AI use case and the PD calibration would have been managed within policy, and the subsequent regulatory fines and reputational damage would have been avoided.

Top tips for establishing a positive model risk culture

Once you know the benefits of a positive model risk culture, the next question is how you go about creating one. If you’re looking for somewhere to start, we’d suggest…

• Training and education: Educate the board, key stakeholders and model users in model risk and the implications if it goes wrong.
• Easily understood frameworks and policies: Use relatable examples of what models and use cases look like to maximise understanding and buy-in.
• Changing who owns the risk: Rather than just allowing management to ‘risk accept’ model risks, reiterate the mandate to remove any models that aren’t fit for purpose. This encourages the business to address model issues in a timely manner.
• Identifying your model risk champions: They can be an effective way to create localised specialists with specific MRM objectives.
• Offering business incentives: Don’t just expect people to align with this new culture overnight. Incentivise them for displaying the right behaviours.
• Repeating it over and over: Change must be consistently applied if people are to know that this is the new norm. Keep showing the benefits and spreading the message.
• Regular monitoring: This will provide assurance that the culture is being embedded, which can be completed via model risk reporting and (for example) prompt and timely closure of validation actions.

What does success look like?

You’ll know your culture is changing in the right direction when you can see an observable shift in behaviours at all levels of the organisation. That means more proactive cross organisational engagement in MRM.

The ultimate outcome? Improved decisions, results and regulatory compliance.

How can 4most support?

At 4most, we work with a range of international clients and have built up a broad view of how the MRM landscape is changing. We have specialists with different expertise across financial services, enabling us to truly understand our clients’ needs.

What’s next?

For more guidance on achieving robust MRM, you can read our in-depth blogs on…

• The three core elements of robust MRM
• Keeping pace through controlled innovation
• Improving MRM efficiency

Or you can read our specialist guide…

… and get the latest best practice guidance for MRM. You can learn more about the guide here, or you can read it straight away by clicking this link.

Need our support? Let us know how we can help you establish a positive model risk culture by completing our short contact form.