94. Models have become an integral part of decision-making in the banking sector for risk management, business decisions, and accounting. Inaccurate model results, e.g. based on wrong assumptions or valuations, may lead to actual or potential financial losses or an underestimation of risks. Therefore, the Central Bank considers model risk a significant risk type.

95. Simple models should not be confused with poorly designed models. Poorly designed models can be misleading and interfere with sound decision-making. Small and/or unsophisticated banks can employ simple models. However, they cannot employ poorly designed models. Each bank should manage model risk in accordance to the Central Bank Model Management Standards and Guidance.

96. Model risk should be incorporated in each banks’ risk framework alongside other key risks, as inherent consequences of conducting their activities (refer to Appendix 3.2). Consequently, model risk should be managed through a formal process incorporating the bank’s appetite for model uncertainty. The framework should be designed to identify, measure, monitor, and mitigate this risk. A bank should mitigate a large appetite for model risk by counter-measures such as conservative buffers on model results and/ or additional allocated Pillar 2 capital.

97. The Central Bank recognises that the estimation of model risk is challenging. However, each bank should demonstrate that they have implemented steps to measure the potential losses arising from model risk. At minimum, each bank should implement a grouping approach to categorise models according to their associated model risk. The uncertainty and losses arising from models should be estimated by using a range of different techniques, including:

98. Each bank should also consider the quality of its model risk management in the model risk analysis, including but not limited to the quality of model documentation, data, assumptions, validation, staff, implementation, and usage.

Risk Diversification Effects

99. Each bank is expected to take a prudent approach whenever assuming risk diversification effects. Furthermore, each bank should be aware that the Central Bank as a matter of principle will not take into account inter-risk diversification in the SREP. Banks should be cognisant of this when applying inter-risk diversification in its ICAAP.