OCC guidance on model risk management and model validations

In 2011, the Federal Reserve System (FED) and the Office of the Comptroller of the Currency (OCC) jointly published SR 11-7 which was related to guidance on model risk management and model validations. The guidance is intended for use by banking organizations to assess their organization’s management of model risk. Since 2011, financial institution models have been widely used, however, the results from most of those models have not directly impacted the organization’s financial statements. The adoption of Accounting Standards Update (“ASU”) No 2016-13, Financial Instruments – Credit Losses (Topic 326) that amended accounting for current expected credit losses (CECL) has changed that. Now, model estimates and the possible adverse consequences of decisions based on models being incorrect can directly impact financial statements of all financial institutions. As a result, in 2020, the OCC, FDIC, Federal Reserve, and NCUA issued a joint final interagency policy statement related specifically to the allowance for credit losses (ACL). This statement describes validation considerations related to the CECL estimation process and the importance of obtaining an independent validation of your CECL estimate to properly verify the models used within the organization.

Model validation is the set of processes and activities intended to verify that models are performing as expected and in line with their design objectives and business uses. An effective model validation challenges the model’s data, design, assumptions, and estimates, assesses if proper governance has been established, and finally back-tests the assumptions to actual performance. All model components from the front-end model governance to the back-end reporting analytics and everything in between (data inputs, assumptions, forecasting) should be part of the validation process.