The challenge of governing model risk

ETH Risk Day 2013

Dr. Susanne Brandenberger

Head Risk ControlVontobel Group

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Slide 2

Focus on Model Risk

Lessons learnt from financial crisis

� More attention on risk management and model validation in general

� Focus on «mark to model» valuations (IFRS level 2/3 valuations) and independent validation processes for pricing models

� Refinements of «best practices» as well as new regulatory standards

Regime shifts in markets

� Extraordinary high credit spread levels

� Extraordinary low and negative interest rates

Products

� More complex models for same products

� Hybrid products (e.g. autocallables) and difficult to measure input parameters (e.g. correlations)

Accounting Challenges� FVA, DVA, CVA ….

Model Risk in Practice: Valuation of caps and floors with negative interest rates

Starting Point:

Decision by Swiss National Bank to defend a CHF/EUR

FX rate of 1.20 leads to negative par swap rates and overnight rates (TOIS) for

CHF

-> negative forward rates

-> Black76’ model assumes log

normal dynamic of forward rates i.e. negative rates are not possible

-> the market assumes relatively high movements also for very low

rates however; premiums for floors can be substantial

Slide 3

Source: Bloomberg

Par swap rate for 3yr tenor against 3M libor

Model Risk in Practice: Valuation of caps and floors with negative interest rates

ICAP Black76 implied Vol CHF 1Yx3M ATM Cap in

Bloomberg:

-> Volatilities in the Black 76’ Model explode for Options with low strikes and strike «0»

-> Valuation with the Black 76’

Model is not possible given these market parameters

Slide 4

Source: Bloomberg

Model Risk in Practice: Valuation of caps and floors with negative interest rates

Slide 5

Black76 implied Vol Surface EUR 19.4.2013 Displaced Diffusion Vol-Surface EUR 19.4.2013 (Shift 1%)

� Log normal assumption for forward rates is no longer valid in low interest rate environment

� Black76 – model (or any other model based on lognormal assumption) can not be used-> use of normal model or displaced diffusion model (normal SABR)

Source: Calculations by Vontobel

Slide 6

What is Model Risk?

Model Risk =

«The possibility that a financial institution suffers losses due to mistakes in the

development and application of (valuation) models.»

Morini [2011], p. 3

What kind of models?

� Pricing/Valuation/Hedging Models

� Risk Aggregation Models; Regulatory capital models

� Forecasting models, Performance models, …

What kind of losses? - Pricing/Valuation/Hedging Models

� Losses over time due to underestimation of hedging costs e.g. selling optionality at

too low prices

� Losses due to a regime shift in the market and/or in the market consensus on the

«right» model

� P/L hit due to immediate adjustment of mark-to-model valuation caused by failure of internal processes and controls

Slide 7

Pricing and Risk Models

HistoricMarket Data

Positions

Aggregated

RiskReporting

(VaR, Stress)

Scenario-Generator

Instruments

(Static Data)

(Re-)Valuation-Engine

Aggregation-Engine

Actual

Market Data

Models (yield curves,

Volas, …)

Pricing / HedgingModels

Valuations

Hedge Param.

P/L

Reporting

Slide 8

Management and Mitigation of Model Risk

Quality ManagementIndependent Review and

Controls

Model ReservesFair Value Adjustments

Parameter / Price Verifica-

tion (IPV)

Model

Validation

Fair Value =

Theoretical Value + Model Reserve

Model Reserve to cover risk due to• parameter uncertainty

• model risk Analysis of

daily P/L

Analysis of collateral

disputes

Slide 9

Model Validation - Tasks and Responsibilities

Business Unit / Model Owner → «Risk Taker and Fist Line of Defense»

� Responsible for ensuring that models are properly developed, implemented, and

used

� Accountable for model use and performance (within the framework set)

� Model documentation

Risk Control → «Second Line of Defense»

� Responsible for management of independent validation and review process

� Accountable for effective challenge of models and their implementation and use

� Responsible for defining any restrictions and limits on model usage

� Documentation: Model validation reports and inventories

� Responsibility allocated to individuals and committees

Audit → «Third Line of Defense»

� Assessment of overall effectiveness of model risk management framework

Slide 10

Model Validation - Processes

Model Validation and Approval

� Clearly defined multi-stage internal process for implementation of a new or change of anexisting model:

– Qualitative validation: Assumptions and numerics

– Quantitative assessment– Independent benchmarking

� Applicable for vendor as well as proprietary models

� Output of process is approval (yes/no), often with specific requirements for improvements or

restrictions

Approval for «Prototyping»

� Approval for restricted use of proprietary developed models within tight limits and restrictions(products, volumes, …)

� Partial validation and approval procedure

� Only possible for limited time period, at the end of period full validation or withdrawal ofapproval.

Periodic Model Review

� Periodic review of relevant models

� Challenge of identifying «relevant» models, i.e. based on sensitivities (“Greeks”)

Slide 11

Model Validation - Tools

Validation Tools:

� Testing framework

� Benchmark library

“Model Inventory”:

� Short model description

� «Model mapping»: Classification of products with models used to price them

� Restrictions regarding use for certain products

� Documentation and assessment of input parameters

� Developer

� Information on implementation

� Validation approach, date of validation and approval; Open issues and deadlines

� Model documentation as well as model validation documentation.

Periodic Management Reporting:

Statistics on models, volumes and «risk ratings»:

� Full Validation with/without open issues;

� partial validation / “Prototyping”

� Pending validation for certain time periods

Slide 12

Governance - «Effective challenge» of Models

� Definition of tasks and responsibilities

� Allocation of resources needed

� Definition of reporting, control and

escalation procedures

� Definition of internal guidelines regarding organization and processes

→ Incentives; Segregation of duties

→ Competence

→ Influence

Slide 13

References

Basel Committee on Banking Supervision (BC): «Supervisory guidance for assessing banks’ financial instrument

fair value practices», April 2009.

Board of Governors of the Federal Reserve System / Officer of the Comptroller of the Currency (FED):

«Supervisory Guidance on Model Risk Management», April 4, 2011.

Derman, Emanuel: «Markets and models», Risk Magazine, July 2001, p.

Derman, Emanuel: «The Principles and Practice Of Verifying Derivatives Prices», April 2001.

Elices, Alberto; «The role of the Model Validation function to manage and mitigate model risk», November 2, 2012.

Morini, Massimo: «Understanding and Managing Model Risk», Wiley, 2011.

Rebonato, Riccardo: «Theory and Practice of Model Risk Management», Quantitative Research Center (QUARC)

of the Royal Bank of Scotland, 2003.