April 4, 2011
OCC Lays Out Supervisory Expectations for Banks Using Quantitative Models
WASHINGTON — The Office of the Comptroller of the Currency (OCC) issued guidance today that provides a clear statement of expectations for banks that use quantitative models in any aspect of their business. The guidance addresses "model risk," which is the potential for damage when models play a material role in bank decision making.
"Model risk should be treated like other risks," Mark Levonian, Senior Deputy Comptroller for Economics at the OCC said. "Banks need to identify the sources of risk, assess the magnitude of the risk, and take steps to control that risk."
The new guidance, developed jointly with the Board of Governors of the Federal Reserve System, describes a number of important risk management practices related to model use, including "effective challenge" of models through model validation, strong governance, internal audit coverage, and clear internal policies and documentation.
Banks routinely use models for a broad range of activities. In recent years, banks have applied models to more complex products and with more ambitious scope.
The guidance notes that while these models can be important and valuable tools for banks, and can improve business decisions, they also introduce new risks, and those risks must be managed by banks.
Although many banks already follow at least some of these practices, the OCC expects all national banks to consider the new guidance and modify their model risk management frameworks as necessary. The OCC has a specialized staff of PhD-level economists, mathematicians, and financial experts who will work with OCC examiners in the banks as they apply this guidance.
Mr. Levonian noted that "just as most car accidents are the fault of the drivers, not the cars," many of the model-related problems of recent years have stemmed from improper use of models or from weak internal governance processes, rather than from failure of the models themselves. "Banks cannot just focus on whether models ‘work’ in a technical sense – they have to focus on how the models are being used, that is, on the business context," Mr. Levonian said.
The guidance is explicitly designed to be tailored to each bank’s situation, with the nature and extent of model risk management activities commensurate with a bank’s risk exposures and business activities, and with the extent and complexity of the models the bank uses. Banks that make limited use of models, or use relatively simple models – as is the case at many smaller banks – are likely to take a correspondingly less complex approach to complying with the supervisory expectations in the guidance.
"This guidance is an important step forward in ensuring that national banks continue to operate safely and soundly, while at the same time allowing banks and their customers to reap the benefits of new technology and the ongoing evolution of financial and economic modeling," Mr. Levonian said.