At a recently held panel discussion hosted by the Professional Risk Managers' International Association of New York featured panelists from Credit Suisse, the Structured Products Association and Numerix provided their perspectives on the challenges and opportunities in dealing with model risk. As the moderator of the event, Numerix CMO, Jim Jockle offers his reflections on the debate taking aim at the heart of the the issue. He asks:
‘Has the mandate to more closely manage model risk stifled the structured products industry, or pushed it to new heights in terms of innovation?’
He concludes that while many of the challenges have been well documented, necessity is indeed the mother of all invention. He offers his insights on this issue from three perspectives: regulation, standardization and technology.
Jim Jockle (Host): Hi welcome to Numerix Video Blog, your expert source for derivatives trends and topics. I’m your host Jim Jockle. At a recently held panel discussion, “Challenges and Opportunities in Dealing with Model Risk” Hosted by PRMIA, the esteemed panel of Market experts from Credit Suisse, the Structured Products Association, and Numerix endeavored to answer a very difficult question: has the mandate to more closely manage model risk stifled the structured products market industry, or has it been pushed to new heights in terms of innovation?
Well let’s look at the question from three key perspectives: Regulation, Standardization, and Technology Innovation.
The flurry of Model Risk guidance proposed by regulators over the past several years is no doubt broad and encompassing and from the basic definition of a model, to how the actual validation process occurs, there is significant room for subjectivity. On the flip side, models in the verification process, have definitely become the hot new area for internal risk management personnel, and a real partnership is starting to evolve between the banks front office and model validation staff. This type of collaboration can only be seen as a positive.
As far as bringing standardization to the market, model validation, of course, is only one part of a larger whole. It is not easy to come up with consensus on a single topic in the structured product market, especially when trying to harmonize priorities for issuers, distributors, and compliance. However, so much change around one topic can also act as a catalyst encouraging an industry to band together to establish a standardized approach. A recommendation for model validation best practices might be beneficial, and even welcomed, if the industry has a benchmark to follow.
To build and validate a structured product model, is a slow and manual process, typically sometimes 6-18 months. And there’s no getting around the fact, that the more complex the modelling to capture the cross-asset underlying’s and the risk factors, the market opportunity is at significant risk of being missed. However, no matter how you slice it, the opportunity to fast-track models to take advantage of market opportunity. However, no matter how you slice it, the opportunity to fast track models to take advantage of market opportunities is a very appealing notion. By way of innovation some have even suggested new mathematical approaches to model testing that would ultimately automate the model validation process – helping institutions to achieve consistent, thorough validation and faster time to market.
This is going to be an area that will continue to be hotly contested over the next couple of months.
Especially around new regulations, as specific within CCAR and DFAST in the United States, where new rules are being introduced for model validation. But more importantly, the question of independence of model validation and the front office while can be streamlined, it is imperative that institutions think about the way that incentives are aligned to ensure the spirit of the regulation, is met. Going forward, lots to be covered on this, and hopefully we’ll have more standardization and best practices to talk about in the near future. And it’s our goal to talk about the topics that you want to talk about on the Numerix video blog, and examine these challenges. Join in on the conversation on LinkedIn, on Twitter @nxanalytics, and we appreciate your feedback as we’re going to keep this conversation going. Thank You.