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FRM Part II · FRM Exam Part II · Supervisory Guidance on Model Risk Management

A bank uses three models that all rely on the same vendor-supplied volatility surface: a pricing model, a VaR model and a limit-setting model. Validation of each model separately rated it low risk. A reviewer argues the aggregate model risk is understated. Which is the strongest justification?

The strongest justification is that a common vendor input creates a concentrated dependency: one error in the volatility surface would flow through pricing, VaR and limits at once. Separate low ratings miss this correlated failure, so aggregate model risk is understated.

  1. AThe three models are in different business lines, so errors cancel out
  2. BVendor data are always more reliable than internal data, so risk is overstated
  3. CIndividual validation covers outcomes analysis, so aggregation adds nothing
  4. DA common input creates a concentrated dependency, so an error in the surface would propagate across all three models simultaneouslyCorrect

Explanation

Shared inputs create correlated failures. A flaw in the volatility surface would distort pricing, VaR and limits together, so the combined impact exceeds what separate low ratings suggest. Assuming errors cancel is unsupported, and individual validation does not capture cross-model dependency.

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