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

A bank's mortgage prepayment model has been validated and approved. Over two years, management adds several manual overrides to outputs, the model is applied to a new product segment, and a vendor silently updates a third-party input library. Which view of model risk is most appropriate for a validator assessing the bank?

Model risk can emerge or grow throughout the model's life. New segments, manual overrides and silent vendor updates change how the model behaves and is used, so ongoing monitoring and revalidation are needed; initial approval and vendor responsibility do not remove it.

  1. AModel risk arises only at development, so the initial validation remains sufficient
  2. BModel risk can emerge or grow over the model's life from changes in use, overrides and dependencies, requiring ongoing monitoring and revalidationCorrect
  3. COverrides eliminate model risk because human judgment corrects errors
  4. DVendor updates transfer model risk to the vendor, so no action is needed

Explanation

Risk evolves through new uses, overrides and changed components, so initial approval does not cover them. Overrides add judgment risk rather than remove it, and vendor models remain the bank's responsibility to validate and monitor.

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