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FRM Part II · FRM Exam Part II · Case Study: Model Risk and Model Validation

A bank's credit team relies on a purchased scoring model whose vendor will not disclose the code. Which action best mitigates the model risk arising from this arrangement?

The bank should validate the vendor model independently using outcomes analysis, benchmarking and sensitivity testing, and document its limitations and compensating controls. Vendor models remain the bank's responsibility, so the vendor's own report cannot replace the bank's independent challenge.

  1. AAccept the vendor's validation report as a full substitute for the bank's own validation
  2. BRun the model only on portfolios with the lowest balances to limit the impact of errors
  3. CPerform independent validation using outcomes analysis, benchmarking and sensitivity testing, and document the limitations and compensating controlsCorrect
  4. DRemove the model from the inventory because it is not developed in-house

Explanation

Supervisory guidance expects vendor models to be validated by the bank as thoroughly as possible, even when the code is a black box. Outcomes analysis, benchmarking and sensitivity tests, plus documented limitations and compensating controls, address this. Relying only on the vendor's report fails the requirement for independent, effective challenge.

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