This intensive course addresses the subject of model risk and stress testing from a practical perspective. In July 2009, the Basel Committee on banking supervision issued a directive requiring financial institutions to quantify model risk and that two types of risks need to be addressed:
i. The model risk associated with using a possibly incorrect valuation; and ii. The risk associated with using unobservable calibration parameters.
Although adjusting Tier 1 capital in light of model risk seems to be a simple modification to the market risk framework, quantifying model risk is a much more complex problem because the source of risk (using an inappropriate model) is much harder to characterise. Relying upon both the growing body of industry and academic literature, along with regulatory guidance, the purpose of this course is to present the current state of the art in quantifying the two types of model risk and what constitutes applying a consistent framework. In light of Basel requirements we will look at the challenges in involved in market, credit and operational model risk, at individual, portfolio, and enterprise-wide level.
The second topic of stress testing follows-on from model risk because it may use less transparent, illiquid parameters and involve models which may be miss-specified, inappropriate, or even defective. Like the subject of quantifying model risk, useful stress testing is a key requirement of adequate risk governance.
√¢‚Äî¬è Understanding the various forms of model validation√¢‚Äî¬è Getting to grips with model typology√¢‚Äî¬è Model risk and audit assurance√¢‚Äî¬è Developing a model risk management framework√¢‚Äî¬è Key principles of stress testing√¢‚Äî¬è Developing stress testing frameworks√¢‚Äî¬è Portfolio stress testing methods√¢‚Äî¬è Asset quality review√¢‚Äî¬è Enterprise-level stress testing√¢‚Äî¬è Expected results and outputs
COURSE CONTENTKey Concepts• Statistics & inductive reasoning• The nature of model risk• The role of models and marking to model• Different interpretations of model risk
Model Usage and Risk• Pricing models• Portfolio models• Hedging models
Forms of ModelValidation• Theory & specification• Implementation• Application• Data sources• Time horizon• Calibration frequency• BIS validation standards
Model Risk Typology• Applicability of modelling• Model correctness• Incorrect solutions• Incorrect usage• Approximation error• Software & hardware problems• Data stability
Model Risk and AuditAssurance• Model review• Algorithms• Processes• Documentation• Model evaluation• Model assurance• Five C’s of audit assurance
Model Risk ManagementFramework• Risk assessments• Audit planning• Audit testing• Control evaluation• Audit points and correction• Issue closure and verification Stress Testing – Key Principles• Purpose of stress tests• Frequency and timing of stress tests• Coverage of stress tests• Disclosure• Scenario design• Application of scenarios• Amplification & feedback• Engagement & communication
Stress Testing Logic andRationale• Regulatory background & requirements• Basel II provisioning• Basel II/III-related criteria for assessing risks• Qualitative and quantitative measures for risk assessment• Alternative types of stress tests• &n