The Board of Governors of the Federal Reserve System’s SR 11-7 supervisory guidance (2011) provides an effective model risk management framework for financial institutions (FI’s). SR 11-7 covers everything from the definition of a model to the robust policies/procedures that should exist within a model risk management framework. To reduce model risk, any FI should consider following the guidance throughout internal and regulatory processes as its guidelines are comprehensive and reflect a banking industry standard.
The following items and quotations represent an overview of the SR 11-7 guidelines (Board of Governors of the Federal Reserve System, 2011):
- The definition of a model – “the term model refers to a quantitative method, system, or approach that applies statistical, economic, financial, or mathematical theories, techniques, and assumptions to process input data into quantitative estimates.”
- A focus on the purpose/use of a model – “even a fundamentally sound model producing accurate outputs consistent with the design objective of the model may exhibit high model risk if it is misapplied or misused.”
- The three elements of model risk management:
- Robust model development, implementation, and use – “the design, theory, logic underlying the model should be well documented and generally supported by published research and sound industry practice.”
- Sound model validation process – “an effective validation framework should include three core elements: evaluation of conceptual soundness, …, ongoing monitoring, …, and benchmarking, outcomes analysis, …”
- Governance – “a strong governance framework provides explicit support and structure to risk management functions through policies defining relevant risk management activities, procedures that implement those policies, allocation of resources, and mechanisms for evaluating whether policies and procedures are being carried out as specified.”
The majority of what the SR 11-7 guidelines discuss applies to some of the new aspects from the accounting standard CECL (FASB, 2016). Any FI under CECL regulation must provide explanations, justifications, and rationales for the entirety of the CECL process including (but not limited to) model development, validation, and governance. The SR 11-7 guidelines will help FI’s develop effective CECL processes in order to limit model risk.
Some considerations from the SR 11-7 guidelines in regards to the components of CECL include (but are not limited to):
- Determining appropriateness of data and models for CECL purposes. Existing processes may need to be modified due to some differing CECL requirements (e.g., life of loan loss estimation).
- Completing comprehensive documentation and testing of model development processes. Existing documentation may need to be updated to comply with CECL (e.g., new models or implementation processes).
- Accounting for model uncertainty and inaccuracy through the understanding of potential limitations/assumptions. Existing model documentation may need to be re-evaluated to determine if new limitations/assumptions exist under CECL.
- Ensuring validation independence from model development. Existing validation groups may need to be further separated from model development (e.g., external validators).
- Developing a strong governance framework specifically for CECL purposes. Existing policies/procedures may need to be modified to ensure CECL processes are being covered.
The SR 11-7 guidelines can provide FI’s with the information they need to start their CECL process. Although not mandated, following these guidelines overall is important in reducing model risk and in establishing standards that all teams within and across FI’s can follow and can regard as a true industry standard.
Resources:
- Board of Governors of the Federal Reserve System. “SR 11-7 Guidance on Model Risk Management”. April 4, 2011.
- Daniel Brown and Dr. Craig Peters. “New Impairment Model: Governance Considerations”. Moody’s Analytics Risk Perspectives. The Convergence of Risk, Finance, and Accounting: CECL. Volume VIII. November 2016.
- Financial Accounting Standards Board (FASB). Financial Instruments – Credit Losses (Topic 326). No. 2016-13. June 2016.
Samantha Zerger, business analytics consultant with FRG, is skilled in technical writing. Since graduating from the North Carolina State University’s Financial Mathematics Master’s program in 2017 and joining FRG, she has taken on leadership roles in developing project documentation as well as improving internal documentation processes.