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FRM Part II · FRM Exam Part II · Validating Bank Holding Companies' Value-at-Risk Models for Market Risk

A validation team at a bank holding company reviews its VaR model. It performs backtesting comparing daily VaR to P&L, but does not examine the model's data inputs, mapping of positions to risk factors, or code. A senior reviewer criticizes the approach. Which criticism is most appropriate?

Outcomes analysis alone is insufficient. Validation should also evaluate conceptual soundness, data quality, position mapping and implementation, because backtests have limited statistical power and can fail to reveal model weaknesses. Backtesting remains useful but must be complemented by other validation components.

  1. ABacktesting is irrelevant to validation because VaR is only a theoretical number
  2. BOutcomes analysis alone is insufficient; validation should also include evaluation of conceptual soundness, data quality and implementation, since backtests have limited power to detect model flawsCorrect
  3. CValidation should rely only on input data checks because backtesting results are too precise
  4. DValidation should only be carried out by the model developers to preserve expertise

Explanation

Backtests have low statistical power, especially at 99% with about 250 observations, so they can miss deficient models. A complete framework combines outcomes analysis with review of design, data, mapping and implementation. Developer-only validation lacks independence.

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