1 – Why Model Risk Matters
Model risk is a topic of great, and growing, interest in the risk management arena. Financial
institutions are obviously concerned about the possibility of direct losses arising from mis-marked
complex instruments. They are becoming even more concerned, however, about the implications that
evidence of model risk mismanagement can have on their reputation, and their perceived ability to
control their business.
Model risk inhabits, by definition, the opaque area where the value of instruments cannot be
fully and directly ascertained in the market. The valuation of these products must be arrived at by
means of marking-to-model, and therefore always contain a subjective component. In these days of
heightened sensitivity to aggressive or opaque accounting, the ability to rely on sound practices to
control model risk can have share-price implications well beyond the monetary value of the mismarked
positions. It is also for this reason that financial institutions place increasing importance on
the effective management of model risk. Unfortunately, there is a widespread lack of clarity as to
what model risk management should achieve, and about which tools should be used for the purpose.
In this chapter I intend to answer these questions, to provide theoretical justification for my views and
to suggest some practical ways to tackle the problem.