FRM Part II · FRM Exam Part II · Governance
A bank's model risk policy requires a tiering of credit models. A newly developed loss given default (LGD) model drives loan pricing and regulatory capital for a large wholesale portfolio, relies on scarce data, and uses complex machine-learning techniques. How should the model be treated under sound model risk management?
The model should be classified as high materiality and complexity, with enhanced independent validation, conservative adjustments for limited data, ongoing monitoring and defined limits on use. It drives capital and pricing, so scarce data and complexity raise model risk; in-sample fit or documentation alone is insufficient.
- AClassified as high materiality and complexity, with enhanced validation, conservative adjustments for data limits, ongoing monitoring and defined limits on useCorrect
- BClassified as low risk because LGD is only one of several inputs to expected loss
- CExempted from validation because the developer documented the methodology thoroughly
- DApproved for use once back-testing on the development sample shows a good fit
Explanation
Model risk depends on materiality of use and on complexity and data uncertainty. This model affects capital and pricing, has scarce data and is complex, so it warrants the highest tier with rigorous independent validation, conservatism and monitoring. Good in-sample fit is not evidence of out-of-sample performance, and documentation does not replace validation.
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