FRM Part II · FRM Exam Part II · Supervisory Guidance on Model Risk Management
A bank built a credit card loss-forecasting model on data from a long benign expansion. The model is mathematically sound and was implemented without coding errors. During a recession, the model badly underestimates losses and management cuts provisions based on it. Which source of model risk, as described in SR 11-7, is most directly illustrated?
The best fit is a fundamental error in the model: its assumptions and development data, drawn from a benign period, did not capture stressed conditions, so outputs were inaccurate. Correct code does not prevent this, which is why SR 11-7 stresses data suitability and assumption testing.
- AA fundamental error from the model's assumptions and data not reflecting stressed conditions, so outputs are incorrectCorrect
- BIncorrect use of the model only, because the model itself was entirely correct
- CVendor risk arising from a lack of access to the source code
- DOperational risk arising from a data-entry mistake in a single report
Explanation
Model risk arises from fundamental errors producing inaccurate outputs, including from assumptions and data that do not fit the conditions faced. Here the training data omitted stress, so the output was wrong for the environment. Option B is wrong because the problem lies in the model's assumptions and data, not just in its application, even though applying it to recession conditions contributed.
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