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

In the JPMorgan Chief Investment Office 'London Whale' episode of 2012, the VaR model for the synthetic credit portfolio was changed in early 2012 and produced a markedly lower VaR figure. Which weakness in model governance does this episode most directly illustrate?

The episode shows that a VaR model change was rolled out without adequate independent validation and approval. Manual spreadsheet errors and flawed calculations went unnoticed, understating risk. Weak model governance, not excessive validation or an inherent historical simulation limitation, was the core failure.

  1. AA model change was implemented without adequate independent validation and approval, and its operational flaws went undetectedCorrect
  2. BThe firm used a historical simulation method that cannot capture tail risk
  3. CThe model was validated too frequently, which created model fatigue
  4. DVaR limits were set by the independent risk function without input from traders

Explanation

The new VaR model was put in place under time pressure without sufficient review and validation, and it contained spreadsheet and calculation errors that understated risk. The other options do not describe the documented failure. Excessive validation frequency was not an issue, and the problem was not that the limits were set independently.

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