Financial institutions are increasing their use of models for business processes, without which they would need to perform simple tasks manually. Although such models have their benefits, they also entail certain risk. Model risk management (MRM) is an essential process for financial institutions to address these underlying issues, and organisations that do not adopt MRM processes may end up paying a hefty price. A simple error within a pricing model could result in losing a fortune. MRM solutions are, therefore, a must in today’s competitive and digital-first financial sector.
Understanding the models used in the financial sector
A model may be considered to be a quantitative representation of a process or operation. Models can be the backbone of software systems responsible for crucial operations. A financial model would outline the proper way to perform a particular task.
Organisations in the financial sector use different types of models such as the following:
- Pricing models are required to determine the right price for assets such as bonds and futures
- Financial institutions depend on statement models to analyse financial statements of an organisation
- Loan providers use credit risk models to determine risk associated with a particular lender
- Financial institutions use economic models to assess the impact of economic changes on policies, financial instruments and operations
- Investment banks use portfolio models to optimise their investments in line with an organisation’s strategy
- Financial institutions use simulation models to determine the outcomes of potential situations
These are just some of the models used by the financial sector. Developers are working on new and sophisticated models for improved operations.
Understanding financial risk management
A financial institution would need to manage several risks, such as credit risk, liquidity risk and economic risk, to maintain continuity. It may lose revenue or cease to exist if it overlooks such risks. For example, it must be cognisant of credit risk when loan repayments are due, as ignoring such risk would lead to extending loans to consumers who cannot repay in time. The process of identifying and mitigating risk is known as financial risk management. The main aim is to prevent financial loss and boost return on investment (ROI).
Financial risk management experts focus only on preventing financial loss and boosting ROI and may not take into account reputational risk, which would be covered by compliance checks conducted by regulatory authorities. However, they would take into account penalties that could be imposed by compliance officers.
Understanding the role of MRM solutions for financial risk management
Financial models could generate loopholes and financial loss for an organisation. With MRM solutions, a financial institution would have a solid framework for identifying and managing risks. These solutions enable checking the efficiency and accuracy of models.
MRM solutions help financial institutions follow a standardised approach to financial risk management – from top management to entry-level employees. Even if an employee knows nothing of risk management, they would be alerted when a model’s accuracy is deteriorating. New-age solutions help automate most MRM processes.
Financial institutions must have a central repository of the models they use. This would help manage the model lifecycle efficiently. MRM solutions help create such a repository and replace models that produce inaccurate results, avoiding financial loss.
