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

A bank's VaR model is thoroughly validated and shows no conceptual flaws. Senior management nevertheless reads the 99% one-day VaR as the maximum possible daily loss and sets desk limits as if losses could never exceed it. Losses then exceed VaR on several days. Which statement best reflects SR 11-7 on this situation?

This is model risk arising from incorrect use of outputs. Even a sound model misleads if users misread VaR as a maximum loss. SR 11-7 expects model limitations to be clearly communicated and users to be challenged, rather than assuming accuracy removes the risk or simply changing the confidence level.

  1. AIt is not model risk, because the model itself was accurate
  2. BIt is model risk from incorrect use of outputs, and effective challenge and clear communication of model limitations are requiredCorrect
  3. CIt is solely a backtesting failure that should be fixed by raising the confidence level to 99.9%
  4. DIt is operational risk only, outside the scope of model risk management

Explanation

SR 11-7 stresses that model risk comes from misuse as well as errors. Treating VaR as a maximum loss ignores its limitations, so it is a use problem. Remedies include reporting limitations and assumptions and effective challenge by informed users. Raising the confidence level does not fix the misunderstanding.

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