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

In the JPMorgan 'London Whale' episode of 2012, the Chief Investment Office changed its VaR model for the Synthetic Credit Portfolio shortly before the portfolio's losses grew. Which feature of the model change and its approval best illustrates a model risk governance failure?

The London Whale model change reflected weak governance: the new VaR model had limited independent validation and operational flaws like spreadsheet errors and manual data transfers, and it understated risk. The lower VaR masked the portfolio's exposure instead of prompting position reductions.

  1. AThe new model was implemented with limited independent validation and operational flaws, such as spreadsheet-based calculations and manual copying of data, and it understated riskCorrect
  2. BThe new model used a historical simulation window that was too long, which is a standard approach and not a governance matter
  3. CThe new model was rejected by the validation team but was still used because regulators required it
  4. DThe new model overstated VaR, which forced the traders to reduce positions prematurely

Explanation

The post-mortem found the new VaR model was approved under time pressure, with weak validation, spreadsheet errors and manual data handling, and it produced lower VaR figures. Overstatement did not occur; the understatement of risk helped mask exposures.

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