Article
Gain confidence ahead of your next regulatory exam: the benefits of completing a thorough model validation
April 19, 2023 · Authored by Ivan Cilik, Sean Statz
When it comes to risk, time is of the essence. Prepare your financial institution for its next regulatory review – and cross the CECL finish line. In this informative article, our financial services specialists explain what the best practices are when considering model validation – from a full review of your model governance to a deep dive into data inputs and assumptions.
In preparation for the Dec. 31, 2022, Current Expected Credit Losses (CECL) implementation dates, banks have focused on developing their CECL model. Now it is time to cross the CECL finish line by completing a thorough model validation. A proper validation will give your institution confidence in its next regulatory review, tie up any loose ends or inconsistencies within the model, documentation or process, and produce an outlook of all types of models, methods, vendors and data to provide recommendations for best practices. Even if your model does not demonstrate any inconsistencies or loose ends, it will ensure the model is operating as intended. A proper model validation is able to answer your most pressing questions: What are we missing? What can we do better? Should we be tracking other data? And most importantly: Are we compliant?
Why perform a model validation?
Model validation is the set of processes and activities intended to verify that models are performing as expected, in line with their design objectives and business uses. The use of models in any case invariably produces model risk, which is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. Model risk can lead to financial loss, poor business or strategic decision-making and reputation damage for your organization. It is prevalent and can be caused by misusing a model in some way or using incorrect data, which is why a flexible and comprehensive model risk management strategy is important for every financial institution.
Until now, most of these model outputs have not made it into financial statements. Hence why CECL model validations are so important – these numbers are now not only used to make informed financial decisions but are also featured in an institution’s financial statements. It is essential to be confident that the model is working as intended and that the data is accurate and complete, and therefore the outputs make sense and are reliable.
