MORNBFI Vol. 1 - Planters Development Bank

APP. Q-4308.12.31Model risk is more likely to arise forinstruments that have non-standard oroption-like features. The use ofproprietary models that employunconventional techniques that are notwidely agreed upon by marketparticipants is likewise more sensitive tomodel risk. Even the use of standardmodels may lead to errors if the financialtools are not appropriate for a giveninstrument.The BSP expects FIs to implementeffective policies and procedures tomanage model risk. The scope of policiesand procedures will depend upon the typeand complexity of models developed orpurchased. However, FIs holding anexpanded license or significant levels ofcomplex investments includingstructured products, should at a minimumimplement the following controls:a. Model development/acquisition,implementation and revisions. The BSPexpects larger, complex FIs to adoptpolicies governing development/acquisition, implementation and revisionof market risk models. These policiesshould clearly define the responsibilitiesof staff involved in the development/acquisition process. FIs should ensure thatmodeling techniques and assumptions areconsistent with widely accepted financialtheories and market practices. Policiesand procedures should be duly approvedby the board of directors and properlydocumented. An inventory of the modelsin use should be maintained along withdocumentation explaining how theyoperate.The BSP also expects that revisionsto models will be performed in acontrolled environment by authorizedpersonnel and changes should be madeor verified by a control function. Writtenpolicies should specify when changes tomodels are acceptable and how thoserevisions should be accomplished.b. Model validation. Before modelsare authorized for use, they should bevalidated by individuals who are neitherdirectly involved in the developmentprocess nor responsible for providinginputs to the model. Independent modelvalidation is a key control in the modeldevelopment process and should bespecifically addressed in an FI’s policies.Further, the BSP expects that the staffvalidating the models will have thenecessary technical expertise.A sound validation process shouldrigorously and comprehensively evaluatethe sensitivity of the model to materialsources of model risk and includes thefollowing:1. Tests of internal logic andmathematical accuracy;2. Development of empirical supportfor the model’s assumptions;3. Back-testing. The BSP expects FIsto conduct backtesting of model results.Back-testing is a method of periodicallyevaluating the accuracy and predictivecapability of an FI’s market riskmeasurement system by monitoring andcomparing actual movements in marketprices or market risk factors withprojections produced by the model. To bemore effective, back-testing should beconducted by parties independent of thosedeveloping or using the model. Policiesshould address the scope of the backtestingprocess, frequency of back-testing,documentation requirements, andmanagement responses. Complex modelsshould be back-tested continually whilesimple models can be back-testedperiodically. Significant discrepanciesshould prompt a model review.4. Periodic review of methodologiesand assumptions. The BSP expects thatFIs will periodically review or reassesstheir modeling methodologies andassumptions. Again, the frequency ofreview will depend on the model butManual of Regulations for Non-Bank Financial InstitutionsQ RegulationsAppendix Q-43 - Page 11