Model.risk.management2015

Mohammad Fheili ⌂⌂⌂ fheilim@jtbbank.com
The Evolution of Modeling Risk &
Compliance

Mohammad Fheili
“Over 30 years of Experience in Banking. Contact Details: mifheili@gmail.com (961) 3 337175
Mohammad has successfully delivered over 1,500 hours of
training to professional bankers.
He served as an Economist at ABL, and Senior Manager at
BankMed and Fransabank: and he currently serves in the
capacity of an Executive at JTB Bank in Lebanon.
In addition, He worked as an Advisor to the Union of Arab
Banks.
Mohammad also served as Basel II Project Implementation
Advisor to CAB and HBTF Banks in Jordan.
Mohammad received his college education (undergraduate
& graduate) at Louisiana State University (LSU), and has
been teaching Economics and Finance for over 25
continuous years at reputable universities in the USA (LSU)
and Lebanon (LAU).
Finally, Mohammad published over 25 articles, of those
many are in refereed Journals (e.g., Journal of Money
Laundering & Control; Journal of Operational Risk; Journal
of Law & Economics; etc.) and Bulletins.”

Model Risk Management….The Yesteryears!
G.I.G.O.
• Garbage In, Garbage Out
G.I.G.O.

The Birth of An Early Model
• Model: A Simple mapping
of the Assets to their
corresponding Risk
Weights, which is given by
the Supervisor. …
• No crisis was born out of
Modeling Errors at the
time, the BCBS dropped
Model Risk Management
from Consideration.
< Basel I, or Standardized Approach >

The Regulator’s Perspective at the Time.
• Local Supervisors looked at the Regulated Financial Institution as:
Assets – Liabilities = Net Worth (Cushion)
Should the Bank encounter
a run‐on‐deposits, there is
the Central Bank as lender
of last resort to save the
day.
Should the Bank
encounter a Large
Scale Default, Deposit
Insurance will save the
day.
The more Capital the Bank
has, the more it is
cushioned against a
possible fall in the value of
its assets.
This is how THE REGULATOR intended to deal
with Financial Crisis since “Deposit Insurance”
and “Lender of Last Resort” have clear
implications on Financial Stability (Needless to
mention facilitating Financial Intermediation)
Capital Adequacy is a “Maintenance
Factor;” However, introduced under the
illusion of an otherwise: Safety (All
Financial Crisis proved else), Solvency
(Purely Accounting), etc.

Asymmetric
World
MAXIMIZE PROFIT subject to:
RISK (Basically Credit),
REGULATIONS (Simple Computation of the Cook Ratio)
The Banking Model…. Early Years
• Banks equipped with Technological advancements,
endowed with Financial Innovations, started to search for ways
to capitalize on Imperfections in Regulations: Capital Arbitrage.
• Banks Ventured into “Internal Models” in the 1990s:
 These models allowed banks to align the amount of risk they
undertook on a loan with the overall goals of the bank.
 Internal models allowed banks to more finely differentiate
risks of individual loans than is possible under The Basel
Accord
 If a loan is calculated to have an internal capital charge that is
low compared to 8% standard, the bank has a strong incentive
to undertake Regulatory Capital Arbitrage
 Securitization is the main means used especially by U.S. banks
to engage in regulatory capital arbitrage
• For Banks, The Balance Sheet:
[A + CA] – [L + CL] = Net Worth (Not a Cushion!)
• Driven by a Desire to Free‐Up Capital, boost up their Liquidity,
and Profitability Banks re‐invented the Banking Model.
• Regulators were well aware of where
banks were going and Blessed the Move:
Securitization was, to a certain extent,
encouraged by regulators.
• Regulators Approved Internal Models without
the Proper Due Diligence.
• Capital Adequacy, at the time, did not
adequately account for Contingent Assets.
• And ….

RISK , REGULATORY, Compliance,
Reporting, Etc. Constraints
RISK .  . .
 Default
 Liquidity
 Maturity
 Others . . .
REGULATORY . . .
 Basel I
 Basel II
 Basel III
 Basel IV (In the making)
 TLAC Requirements
 Sanctions Rules
 USA_FATCA Requirements
 OECD_CRS (1st Reporting 2017)
 AML, Etc. . . .
Uses of Funds Sources of Funds
 Reserves
 Loans
 Securities
 Other
Investments
 Fixed Assets
 .  .  .
 All Types of
Deposits
 Borrowings
 Other
Sources
 Capital
 .  .  .
Off-Balance Sheet
With every
Dollar in
Profit a Bank
Makes, it
MUST satisfy
all these
Regulatory
Constraints
first!
Legal Issues .  . .
From
Originate‐To‐
hold To
Originate‐To‐
Distribute
(Decompose &
Redistribute)
CRS: Common Reporting Standards, essentially inspired by FATCA, is a framework between governments to exchange information obtained from local financial institutions to
combat tax evasions.
TLAC: The Proposed Minimum Total Loss Absorbing capacity requirements for Globally Systemically Important Banks (G‐Sibs). It aims to boost G‐Sibs’ capital and leverage
ratios, ensuring these banks are equipped to continue critical functions without threatening financial market stability or requiring taxpayer support.
Instead of to Off‐
Balance Sheet; now to
Unregulated Shadow
Banking with less
concerns over loan
monitoring & Follow up.
Deteriorated quality of Capital with the
Introduction of new instruments and Tier 3
The Banking Model…. got complicated
These Changes
matter much to
Model Assumptions.

RISK .  . .
 Default
 Liquidity
 Maturity
 Others . . .
REGULATORY . . .
 Basel I
 Basel II
 Basel III
 Basel IV (In the making)
 TLAC Requirements
 Sanctions Rules
 USA_FATCA Requirements
 OECD_CRS (1st Reporting 2017)
 AML, Etc. . . .
 Reserves
 Loans
 Securities
 Other
Investments
 Fixed Assets
 .  .  . Off-Balance Sheet
Legal Issues .  . .
More Risky
Assets are
Unloaded to Off‐
Balance Sheet
In its Latest Version, IFRS 9 speaks of NPAs (non‐Performing Assets) instead of
only NPLs (Non‐Performing Loans).
More Investment in
Complex Financial
Derivatives on all Sides
of the Balance Sheet.
More Capital Requirements by The
Regulator; more Opportunities for capital
Arbitrage….
These Changes
matter much to
Model Construction
& Assumptions.
Less Reliance on Deposit‐
Funding and More on Risky
Borrowing (…roll‐over)
 All Types of
Deposits
 Borrowings
 Other
Sources
 Capital
 .  .  .

 Reserves
 Loans
 Securities
 Other
Investments
 Fixed Assets
 .  .  . Off-Balance Sheet
 All Types of
Deposits
 Borrowings
 Other
Sources
 Capital
 .  .  .

While Regulators were busy building
the railroads on which they will
require Bankers to Travel On.
Banks and Bankers were gearing
up for Dangerous Rock Climbing
– Excessive Risk Taking: MBS,
CDO, CDO2, etc.
Asymmetric
World
Basel 1, 1½, 2, 2½, 3, 3½ or 4 !

The Era of Shadow Banking
• Regulatory Compliance got Complicated yet Comprehensive with the
Introduction of The Basel II Accord: Internal Models were Legitimized, and a
Clear Curriculum was introduced to Graduate from one Model To The Next.
• Regulators continued to look at the Regulated financial Institution the same way
but things have changed:
Assets – Liabilities = Net Worth (Cushion and so they thought)
Not Much ChangeComplex
Securitization
Capital is gradually
failing to serve as a
Cushion with Loss‐
Absorbing Capacity
Driven by Excessive Regulations, Financial Intermediation Migrated to the
Opaque and Unregulated Banking Environment…. Internal Models Became
more Sophisticated and relied on Unreasonable assumptions…. Regulators
remained puzzled by the fast‐moving developments.

The Internal‐Model Maturity Qualifying Criteria
CriteriaCriteria Standardized ApproachStandardized Approach
Internal Ratings Based (IRB) ApproachInternal Ratings Based (IRB) Approach
FoundationFoundation AdvancedAdvanced
Ratings External Internal Internal
Risk Weights
Calibrated on the basis of
External ratings by the
Basel Committee
Function provided by the
Basel Committee
Function provided by the
Basel Committee
Probability of Default
(PD)- The likelihood that
a borrower will default
Over a given time period
Implicitly provided by the
Basel Committee; tied to risk
Weights based on external
Ratings
Provided by bank based
On own estimates
Provided by banks based on
Own estimates
Exposure At Default
(EAD) – the amount of
The facility that is likely
To be drawn if a default
occurs
Supervisory values set by the
Basel Committee
Supervisory values set
by the Basel Committee
Provided by the Bank based
On own estimates
Loss Given Default
(LGD) – the proportion
Of the exposure that will
Be lost if a default
occurs
Implicitly provided by the
Basel Committee; tied to risk
Weights based on external
Ratings
Supervisory values set
by the Basel Committee
Provided by the Bank based
On own estimates; extensive
Process and internal control
Requirements

CriteriaCriteria Standardized ApproachStandardized Approach
Internal Ratings Based (IRB) ApproachInternal Ratings Based (IRB) Approach
FoundationFoundation AdvancedAdvanced
Maturity: the remaining
Economic maturity of
The exposure
Implicit recognition
Supervisory values set By the Basel
Committee Or At National Discretion,
Provided by Bank based On own
estimates
Provided by Bank based on
Own estimates (with an
Allowance to exclude certain
Exposures)
Data Requirements
•Provision Dates
•Default Events
•Exposure Data
•Customer Segmentation
•Data Collateral Segmentation
•External Ratings
•Collateral Data
•Rating Data
•Default Events
•Historical Data to
Estimate PD (5 years)
•Collateral Data
Same as IRB Foundation, plus:
•Historical loss data to estimate
LGD (7 years)
•Historical exposure data to
Estimate EAD (7 years)
Credit Risk Mitigation
Techniques (CRMT)
Defined by the Supervisory
Regulator; including financial
Collateral, guarantees, credit
Derivatives, “netting” (on and
Off balance sheet), and real
Estate
All collaterals from Standardized
Approach; Receivables from goods
And services; other Physical
securities if Certain criteria are met
All types of collaterals if Bank
Can prove a CRMT by internal
estimation
Process requirement (Compliance
With Mini requirements Will be
subject to Supervisory review
Under Pillar II)
•Minimum requirements for
Collateral management
(administration/Evaluation)
•Provisioning Process
Same as standardized, Plus
minimum Requirements to ensure
Quality of internal ratings & PD
estimation and Their use in the
Risk Management process
Same as IRB Foundation, plus
Minimum requirements to
Ensure quality of estimation
Of all parameters
The Internal‐Model Maturity Qualifying Criteria

Bankers/Banks Versus Regulators
• Banks: Migrated Financial
Intermediation to the Unregulated
Financial Sector in the pursuit of
Profits
• …and much more
A Danger the
Regulators
Overlooked at
the time
There isn’t a Single
BCBS Publication that
does not point to the
need to reduce Capital
Arbitrage.
• Regulatory Focus: Capital
Arbitrage and How to Limit
it.
• …and much more

Lenders
Surplus Spending
Units ‐SSUs
• Individuals (Current
Income is GREATER than
Current Expenditures)
• Firms (Earnings in excess of
what the firm needs currently)
• Government (Current
Revenues are in excess of
planned Expenditures)
• Financial
Intermediaries (Funding
is currently GREATER than
investment)
Borrowers
Deficit Spending
Units ‐DSUs
• Individuals (Current
Income is LESS than Current
Expenditures)
• Firms (Earnings falls short of
what the firm needs currently)
• Government (Current
Revenues fall short of planned
Expenditures)
• Financial
Intermediaries (Funding
is currently LESS than
investment)
Traditional Banks
Dealers
Securitization
Money Market Mutual
Funds
Hedge Funds
Finance Companies and Other Non‐Bank Lenders
Money Money
Money
Money
Securities
Loans
Money
Money
Loans
Money
Loans
Money
Securities
Money
Securities
SecuritiesSecurities
Money
Securities
Money
Securities
Shows the Flow of Funds from LENDERS to BORROWERS; not the reverse
Model This !
Shadow Banking

Regulations‐Induced Events
What’s been Happening since:
Regulations-Induced Events

• The Monetary Authority has not paid close attention to
Unregulated Financial Intermediations (e.g., Shadow Banking) as
major Economic Engines.
• The Monetary Authority overlooked the Link between Money and
Real Output: Steady growth in the various measures of money
coupled with volatile changes in real output.
• The Complexity and Cost (i.e., Burden) of Compliance are Rising
exponentially.
• The Basel Accord with a history of Incomplete Implementation:
Basel 1, 1½, 2, 2½, 3, 3½ or 4 !
• Nowadays the US Congress is considering Regulatory Reliefs for
certain size financial institutions (Senate Banking Committee
Chairman Richard Shelby).
Regulation‐Induced Events that Reshaped The Banking Model &
Regulatory Focus.

• The Structure of the Financial Landscape has turned Puzzling.
• Regulations are increasingly becoming very Complex.
• Regulators are increasingly becoming very Demanding.
• Risk Management has taken a backseat to strict Adherence to
ever increasing Regulatory Guidance.
• The Regulatory System is becoming overwhelmingly Complex and
Bureaucratic.
• De‐Risking (which is in effect Re‐Risking) is on the rise!
• The Banking Model has changed from Originate‐To‐Hold to
Originate‐To‐Distribute. In addition, the major changes in the
structure of Assets have not been well balanced (By Regulatory
Guidance or else) with changes in Liabilities.
• Basel’s Excessive Focus on Capital is significantly impacting the
Core of the Banking Industry: Converting Demand & Savings
Deposits into Productive Lending.
Regulatory Focus.

• Internal Models will no longer be used as indicators of an FI’s Risk
Management Maturity. The Regulator will have the final say in the
assignment of Risk Weights.
• In April of 2011 a set of Supervisory Guidance was Jointly issued
by the Office of the Controller of Currency (OCC) and the Federal
Reserve on Model Risk Management and Validation.
• Model Validation has been treated as a Compliance activity as
opposed to a Risk Management Activity by many Financial
Institutions.
• Operational Risk, to date, remains at the bottom of the Priority
List of CROs and, equally alarming, that of Supervisory Authorities.
• The “Quant Jocks”: From Pricing Financial Derivatives in “Opaque
Banking” to CROs in the Regulated Banking.
• From “Velocity of Money” to the “Velocity of Collateral.”: Money
Creation has taken the Unregulated Path.
Next: Regulations
Regulatory Focus.

And On The
Regulatory Front…
It takes so long for the rules to change that by the time they are
creeping into existence the markets have changed!
Regulations

The Basel Accordwith a History of Incomplete Implementation
Basel I
Basel II
Credit Risk
Credit Risk
Market Risk
Operational Risk
1986 proposed
1999 proposed
1988 effective
2007 effective
Basel III
Credit Risk
Market Risk
Operational Risk
Capital Quality
Additional Buffers
Liquidity: LCR, NSFR
2009 proposed
Kick Off in 2011
Amendments
Amendments
Basel 2 ½
Basel 1 ½
Amendments
Basel3½
Basel IV
2015 Anticipated
Kick Off in 20??
• Capital Requirements
• Liquidity Requirements
• Disclosure Requirements
• National Divergences
• Risk Sensitivity
• Use of Internal Models in
Decision Making
• Total Risks = Credit Plus
Market Risks
• Internal Models Emerged
• Later on, Tier 3 Capital
• Enhanced Pillar 2, 3
• Complex Securitization
obtained higher Risk
Weights.
• Trading Books
Regulations
• How Often the Banking Model has Changed
• How often Regulatory Guidelines have changed
• How complex the banking environment has become
• How technology has evolved
• How Many Crisis Have We Had.

Basel III
2009 proposed
2011 effective
Capital
Capital Buffers
Conservation 2.5% & Countercyclical 2.5%
Risk Management
Liquidity
(LCR ≥ 100%) (NSFR > 100%)
Leverage ≥ 3%
Reporting
Less Reliance on External
Rating Agencies
• Increase in common equity requirements from 2% to 4.5%
• In crease in Tier 1 Capital (Going Concern) from 4% to 6%
• Tier 1 Capital can no longer include Hybrid Capital
instruments with an incentive to redeem through features
such as step‐up clauses. These will be phased out
• Tier 3 Capital will be eliminated (Previously used for
Market Risk)
• Credit Valuation Adjustment (CVA) Capital Charge must be
calculated to cover Mark‐to‐Market losses on counterparty
risk to Over‐The‐Counter (OTC) Derivatives.
• Stressed Parameters must be used to calculate counterparty
Credit Risk
• Effective Expected Positive Exposure (EPE) with stressed
parameters to be used to address general wrong‐way risk
(WWR) and counterparty credit risk
• Banks must ensure complete trade capture and exposure
aggregation across all forms of counterparty credit risk (not
just OTC derivatives) at the counterparty‐specific level in a
sufficient time frame to conduct regular stress testing.
• A multiplier of 1.25 is applied to the correlation parameter
of all exposures to financial institutions (meeting certain
criteria) (Asset Value Correlation – AVC)
• Additional Margining required for illiquid derivatives
exposures.
• 100% risk weight for Trade Finance.
• Contractual maturity mismatch
• Concentration of funding
• Available unencumbered assets
• Market‐related monitoring tools; asset prices and liquidity,
Credit Default Swap (CDS) spreads and equity prices.
• LCR by currency
• Results of stress tests should be integrated into regular
reporting to senior management
Basel II += +
++
Regulations
Basel III Changed the Rules of Engagement Dramatically!
Milestone

Regulations
Model this …!

Capital Requirements
for Credit Risk
 Standardized Approach
 Foundation IRB Approach
 Advanced IRB Approach
Market Risk (in line with
1993 & 1996)
 Standardized Approach
 Internal VaR Models
Operational Risk
 BIA – Basic Indicator Approach
 SA - Standardized Approach
 AMA - Advanced Measurement
Approach
Regulatory Framework
for Banks
 Internal Capital Adequacy
Assessment Process
(ICAAP) And Risk Control
Self-Assessment (RCSA)
 Risk Management
Supervisory Review &
Evaluation Process
(SREP)
 Evaluation of Internal
Systems of Banks
 Assessment of Risk Profile
 Review of Compliance with
all Regulations
 Supervisory Measures
Disclosure
Requirements of Banks
 Transparency for market
participants concerning
the Bank’s Risk Position
(Scope of Application, Risk
Management, Detailed
Information on own funds,
etc.)
 Enhanced Comparability
of Banks
Basel II Framework
Pillar 1: Minimum
Capital Requirements
Pillar 2: Supervisory
Review Process
Pillar 3: Market
Discipline
1999 proposed
Basel II
1999 proposed
2007 effective
Regulations

Pillar 1: Minimum Capital Adequacy Ratios
Calculation
Of Exposure
Calculation
of PD/LGD
Calculation
of RWA
Adjustments for
Collateral Valuation
Adjustments for
Credit Mitigants
Netting Balance
Sheet Items
Calculations
Of Risk
Weights
Based on
PD/LGD
Supervisory Risk
Weights and LGD
Standardized Approach
IRB (Foundation)
IRB (Advance)
Value at
Risk
Standardized
Measurement
Methods
Interest Rate Risk
Equity Position Risk
Forex Risk
Commodities Risk
Treatment of Options
Support for all
Three Approaches
Basic Indicator Approach:
Capital is calculated as a
percentage of Gross Income
Standardized Approach:
line of Business Based
Exposure Indicators
Advanced Measurement
Approach: Capital
Computations as per LDA
Credit Risk Traded Market Risk Operational Risk
External/Internal
Rating
Systems
Pillar 2: Supervisory Oversight Pillar 3: Market Discipline
Usage of Metadata which
Enables transparency
Capital for other Risks
Rules-Based Engines Risk Assessment Reports
Capital Adequacy
Reporting
Flexible
Reporting
Quantitative
Reporting-IFRS 7
Qualitative
Reporting-IFRS 7
Basel II
1999 proposed
2007 effective
Regulations
Supervisory Review &
Evaluation Process (SREP)
 Evaluate FI’s Internal Systems
 Assess FI’s Risk Profile
 Review FI’s Compliance with all
Regulations
 Does the Knowledge Exist to do
All That?!

Modeling

From Calculating the Credit Risk Capital Charge
to Modeling Credit Risk,
Regulations –Credit Risk

From Calculating the Operational Risk Capital Charge to Modeling
Operational Risk,
Regulations–Operational Risk

Regulations–Operational Risk

Regulations–Market Risk
Calculating the Market Risk Capital Charge

Early Implementation:
BASIC APPROACH
Satisfactory Knowledge of Risk
Management: STANDARDIZED
APPROACHES
Sufficiently Mature Risk
Management: ADVANCED
APPROACHES
CAPITAL
CHARGE
BASEL II CAPITAL CHARGE (Pillar I: Minimum
Capital Requirements, Pillar II, etc.)
Risk Management Maturity
Improved Risk
Management
Practices
Lower Capital
Charge
The Incentive is in Capital Planning
Regulations
What Basel II
Promoted
What Basel III
Downplayed

Truth Be Told, Basel
III tried to
Specifically respond
to the Crisis …
Sub‐Prime
Lending
Excessive Risk Taking
Housing Prices decline
resulting in sub‐prime
defaults
Sub‐Prime Defaults,
Securitized Assets &
Derivatives Trading
resulted in huge losses
Excessive Leverage &
Poor capital could not
absorb losses fully,
demanding fresh
equity infusion
Huge losses resulted in
a crisis of confidence
causing liquidity to
evaporate
Short‐term borrowing
demanded fresh
borrowing which failed
in liquidity crisis
Firms on the verge of
insolvency; threatening
system failure
Governments step in to
inject capital to
prevent systemic
failure
Capital Conservation &
Counter‐Cyclical
Buffers
Capital Conservation &
Counter‐Cyclical
Buffers
a) Less reliance on external ratings
agencies; b) Credit Valuation Adjustment
capital charge; c) Stress Testing
a) Higher quality & quantity of capital; b)
Leverage Ratio Introduced; c) 100%
weight for Trade Finance
Enhanced Supervisory
Review and Disclosure Two new Liquidity
Ratios
Correlation to financial
institutions will carry more
risk weights to prevent
systemic risk and an overall
collapse
In stressed market situations,
credit rating downgrades of
financial institutions and
securitized products further
lowered valuations and
increased losses.
Securitization
BUT
not Enough!
Regulations

Basel 3½ or IV
2015 Anticipated
Kick Off in 20__
Amendments
Basel 3 ½
The Basel Accordwith a history of Incomplete Implementation
Implications
for Banks
• Capital Requirements
• Liquidity Requirements
• Disclosure Requirements
• National Divergences
• Risk Sensitivity
• Use of Internal Models in
Decision Making
Regulations
Next: Banking Environment
If Basel III tackled all
issues of concerns, why
are we getting ready to
welcome Basel IV (or III
½) ?
The Proposed New
Capital Regime is a
Seismic Shift

Banking Environment
The Complexityof
Banking & Financial
Intermediation
• Induced By Excessive
Regulations
• Exploited By Bankers
with the Help of
Technology and
Innovations

Credit Intermediation
Credit Intermediation has become more market‐based, and No Longer Institution‐Based
Sources of
Funds
Uses of
Funds
Individuals
(With Money to
warehouse)
Households/
Business
Borrowings
Non‐Intermediated
Direct Funding (No Intermediaries)
Households /
Corporations
(With Money to safe
keep)
Households/
Business
Borrowings
Banks “Originate and Hold Loans” Till Maturity.
Traditional Banking (Institution‐Based Intermediation)
Households /
Corporations /
Institutions /
Securities
Lenders / Pension
Funds
(With Money to Invest)
MMMF
Purchases
CP
ABCP
Repos, Etc.
ABS
Intermediation
ABS
Issuance
Loan
Warehousing
Loan
Origination
Household /
Business
Borrowings
Shadow Banking (Multiple and Market‐Based, and Layered Intermediations)
Note: MMF is Money Market Mutual Fund, CP is Commercial Papers, ABCP is Asset‐Backed CP, Repos is Repurchase Agreements, and ABS is Asset‐Backed Securities.
rapid balance sheet growth,
a market rise in leverage, and
a proliferation of complex and difficult‐to‐value financial products.
Banking Environment

ABS, MBS, CDO, CDO2 Camouflaged Risk
About the Underlying Asset.
• Housing prices became unrelated to their actual value.
• People bought homes simply to sell them.
• The easy availability of debt meant people charged too much for
the asset.
About the Banks.
• CDOs allowed banks to avoid having to collect on them when
they become due, since the loans are now owned by other
investors.
• Less discipline in adhering to strict lending standards, so that
many loans were made to borrowers who weren’t credit worthy
(ensuring disaster)
About the CDOs.
• CDOs became so complex that the buyers didn’t really know the
value of what they were buying.
• The Sophisticated Computer‐Based Models for CDOs Valuation is
based on the assumption that housing prices would continue to
go up. When prices went down, the computers couldn’t price the
CDOs.
• The Opaqueness and the complexity of CDOs created a market
panic: Overnight the market for CDOs disappeared!
Banking Environment

Induced Risk & Complexity … but in the Shadow: Camouflaged By
The Rating Agencies and Overlooked by The Regulators.
• Despite the good intentions, ratings agencies and regulators were significant
contributors to the imbalances that culminated in financial crisis.
• The big three Rating Agencies’ (S & P, Moody’s, and Fitch) oligopoly prevailed
–
 Without their ratings, companies could not sell debt instruments.
 An inherent conflict of interest arose; issuers paid the companies for
ratings.
 Many investors depended on those evaluations when purchasing debt
in lieu of a more thorough due‐diligence review.
 Investors ran into further difficulties because the evaluations
frequently lagged material market development.
• The Ratings Agencies were complicit in the growing complacency of investors
leading up to the credit crisis.
 Large structured‐product deals involving complex securities were very
profitable for ratings agencies.
 Issuers had the ability to choose among potential raters,
leading to “ratings shopping.”
 The rating agencies shift from an Investor‐Pay to an Issuer‐Pay
business model degraded the value of the evaluations
provided because the agencies faced little risk from inaccurate
ratings.
Banking Environment
Next: Compliance

Compliance
The Never Easing
Pressure on Sanction

Compliance By Fear …
Higher Probability of De‐
Risking
Non‐Compliance By
Mistake… Due to lack of
understanding … De‐Risking
is a more likely outcome.
Compliance
Since De‐Risking has been on the rise, it must
be that most of us have been complying ’By
Fear’.
We’re becoming increasingly good at COMPLIANCE
BUT not in Assessing & Addressing the RISK of:
• Compliance AND
• that of Non‐Compliance
Moving Risks to Opaque Banking  has proven
to be Very Risky (e.g., Last Financial Crisis)
Compliance

Assessment of The Magnitude of AML Risk
 International Wires
 Internet Banking
 High cash Users
 Suspicious Transactions Report
 Politically Exposed Persons
 Industry / Occupation
 Nationality
 Account Maturity
Compliance
Risk
Bank Clients
Bank Services
Bank Products
Geographies
 Private Banking
 International Correspondent
Banking
 Offshore International Activity
 Account Data
 Transaction Data
 Economic Sanctions
 Non‐Non Cooperative Country
Territories
 Country Watch List
Examples of Risk Measures
Compliance

Assessment of Inherent AML Risk
Inherent
AML Risk
Customer
Base
Product /
Account
Transactional
Business
Strategy
Geography
Portfolio of Product Offerings:
• Sales Finance, Mortgages, Life Insurance,
Anonymous Saving Accounts, ….
• Maturity / Stability; Domicile /
Residency; PEP Status
• E‐Banking; Indirect Customers
Portfolio of Transaction Types:
• Domestic transfers, Cash deposits,
International Checks, International
transfers, …
• Mergers & Acquisition activity
• Business Strategy changes
• Expected growth; product portfolio
expansion; …
• Staff Turnovers
Examples of Risk Factors
Country Risk Rating Models
• Positive Factors (FATF, EU, BIS); Negative
Factors (Sanctions, NCCT, Offshore, …)
1
2
3
4
5
1
2
3
4
5
Policies & Procedures
Governance
Training
Risk Assessment
Customer Risk Rating
KYC, CIP, EDD
PEPs
Screening
Surveillance
Reporting
Record Keeping
Auditing Testing
Control Areas
Compliance
Knowledge Gap

Knowledge Gap
Knowledge Gap
• Who Knows what?
• Is it enough?
• The Regulatory Guideline
Interpreter/Translator?
• The Model Developer?
• The Implementer?
• The User?
• How Wide is the Gap
between Quantitative
Finance and Technology
Skills?

Knowledge Gap
The Players:Are They Adequately and Equally Knowledgeable: IT, Finance, Risk, Regulations, etc.?
Basel
Committee
(BCBS)
National
RegulatorThe Regulated
Banking
Institution
IT Model
Developer
Model
Users
Business
Units
Management
What’s At
Stake…
Modeling
Implementer

The Financial Models
& Model Risk
Management (MRM)

The Unprecedented Volume of Global
Regulations has (and is) Placing Considerable
Demands on the Change Capacity of Banks
Exacerbated by the Dangers of Failing to
Effectively Interpret the Regulatory Agenda and
Manage External Stakeholders’ Expectations.
How Can You Control The Risks and Costs of
Regulations.

General
Ledger
Clients &
Settlement
P & L
Risk
Reporting
Core
Analytical
Engine
Other Models
Predictive
Models
Regulatory
Models
Asset‐Liability
Management
Models
Risk
Models
Business
Strategy
Analysis
Valuation
Models
Pricing
Models
Exposure
Measurements
B ACD
These Risks could
Exist Inside each
Module and in the
Interface between
Two or More
Modules
Interface Between
Two Modules

Model Risks
• Poor Data Quality
• Incorrect Assumptions and
Methodology
• Bad Implementation
• Bad Usage
• Non‐Compatibility nor
Comparability Between Existing
and Newly Acquired Assets.
• No Internal Data for Newly
Developed/Introduced Products.
Model Risk is most simply defined as the
potential for adverse consequences from
decisions based on incorrect or misused
model outputs and reports.
It holds great relevance in today’s markets
because quantitative models are behind
practically all decision‐making in the
financial world – from trading and risk, to
asset liability management, investment
and regulations.
Model Risk is not an area that can be
ignored without consequences.

The Damage for not doing the Job Right
The Financial Institution The Amount Time / Reason
$4‐5 Billions
$1‐2 Billions
$14 Trillions
$5‐7 billions
Long‐Term Capital Management
(LTCM)
National Australian Bank
(NAB)
Global Financial Crisis (GFC)
JP Morgan
1997 / Model Assumptions
2001‐03/Rates Methodologies
2007/Correlation, Assumptions,
Data
2012 / Model Control, Usage

The Predictive Model that Caused the Recent Crisis
Estimated Actual
Ratings 3‐Year default Rate Dafault Rate
AAA 0.001 0.10
AA+ 0.01 1.68
AA 0.04 8.16
AA‐ 0.05 12.03
A+ 0.06 20.96
A 0.09 29.21
A‐ 0.12 36.65
BBB+ 0.34 48.73
BBB 0.49 56.10
BBB‐ 0.88 66.67
Source : Donald MAcKenzie, University of Edinburgh
CDOs Of Subprime‐Mortgage‐Backed
Securities Issued in 2005‐07, %
(Source: The Economist)
This time of growth in CDOs is the
era of “Quant Jocks”: Statistical
experts whose job is to write
computer programs that would
model the value of the bundle of
loans that made up a CDO.

Model Risk Framework & Processes
• Independence of Various
Functions, in particular, the
model development, risk control
and audit functions
• Clear definitions of ownership
with accountability aligned with
incentives and authority
• Effective Change Management
Processes with checkpoints and
defined criteria at each stage
• Emphasis on documentation at
each stage in the model lifecycle
• Dissemination of Model Risk
scores and user education along
with model results
• Recognition of Models as a
“work‐in‐Progress” that need to
be continually re‐examined and
improved, rather than as a one‐
time effort
• Recognition of the fact that
quantitative finance and
technology skills are separate,
but require close collaboration.

Model
Development
Model
Implementation
Model Use
Formalized Control
Framework
FIRST LINE of Defense:
Model Developers,
Owners, and Users
Independent Model
Validation Testing
Annual Model Review
Process
On‐Going Model Risk
Monitoring
Model Risk
Identification and
Measurement
SECOND LINE of Defense: Model Risk Management
Unit
Model Risk
Remediation and
Mitigation
GOVERNANCE and Oversight:
Senior Management and Board
of Directors
Model Use Risk
Escalation
Periodic Model Risk
Reporting
Model Risk Appetite
FrameworkEmbedded in Policies, Procedures, and Roles & Responsibilities
THIRD LINE of Defense: Internal Audit
Audits the contents of and compliance with MRM Policies, Procedures, and Standards with the 1st and 2nd Lines of Defense
Model Risk Management Framework

INDEPENDENT Model Risk Management Staff
Annual Review Process: Primary Components
Annual Risk Assessment
• Re‐Assess each Model’s
inherent risk rating
• Proactively Identify Areas of
Elevated Model Risk
• Assess Relevance and
Sufficiency of Previous
Validation Procedures
• Re‐Measure the Materiality/
Significance of Outstanding
(i.e., Un‐remediated) Model
Risk Issues
• Re‐Evaluate Necessity of
Current Model Risk Mitigants
Action Items
• Affirm previous validation
testing procedures and
results, or
• Perform targeted updates of
previous validation testing
procedures, and/or
• Perform new targeted
validation testing
• Any identified model risk
issues should be measured
and subject to appropriate
remediation and risk
mitigation plans.
Changes in
Bank’s
BusinessChanges in
the Industry
& Economy
Changes in
Regulations
Changes in
Model Use
Performance
Monitoring
Information
Advances in
Industry
Modeling
Methodology

In Closing …
Thank You

Model.risk.management2015

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