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

A bank's credit card loss forecasting model has sound mathematical design and was validated at launch. Two years later, the bank starts lending to a new customer segment with very different behavior, yet the model is applied unchanged to it. Which source of model risk does this most directly illustrate?

This illustrates inappropriate use of a model. SR 11-7 says model risk arises from fundamental errors and from incorrect or inappropriate use. The model was sound for its original population, but applying it unchanged to a different customer segment is use outside its intended design, producing unreliable outputs.

  1. AA fundamental error in the model's mathematical specification
  2. BIncorrect or inappropriate use of the model outside the setting for which it was designedCorrect
  3. CData entry mistakes in the historical loan tape
  4. DFailure of the model to be documented

Explanation

SR 11-7 identifies two main sources of model risk: fundamental errors in the model that produce inaccurate outputs, and incorrect or inappropriate use of a model. Here the model is sound, but is applied to a population it was not built for, so the problem is misuse. The specification is not the issue, and nothing indicates data entry or documentation faults.

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