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Model risk management in stress testing: The road up to here

Author

Listed:
  • Canabarro, Eduardo

    (Financial Analyst and Investor, USA)

Abstract
This paper reviews the historical evolution of the quantitative models, model usage and model risk management (MRM) in large US banks since the 1980s. It comments on the most significant model-related events through this period. Some of these events were associated with contexts of great stress to the financial system. The paper identifies the main features of modelling in finance and economics that distinguish it from its application in the natural sciences. Then it presents the different types of models used in the large banks' stress testing programmes, the specific characteristics and risks of each type of model and the best practices for the implementation of sound model risk management, and it suggests a proper way to interpret the results of stress testing and capital assessment in the presence of model risks. The paper discusses the future evolution of MRM towards the implementation of a `fully fledged risk management framework` along the lines of other risk management disciplines, including risk identification, measurement, monitoring, reporting, limiting and capitalisation. It acknowledges the enhancements and opportunities offered by advances in the use of artificial intelligence and machine learning as well as increases in computational power. The paper concludes by noting that the model risk management framework that has been enforced by the Federal Reserve's stress testing and capital planning programmes has substantially strengthened the capital position, profitability and resilience of the large banks in the US.

Suggested Citation

  • Canabarro, Eduardo, 2024. "Model risk management in stress testing: The road up to here," Journal of Risk Management in Financial Institutions, Henry Stewart Publications, vol. 17(4), pages 370-382, October.
    • Handle: RePEc:aza:rmfi00:y:2024:v:17:i:4:p:370-382
    as

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    More about this item

    Keywords

    stress testing; capital planning; model risk; models; CCAR; DFAST; banks;
    All these keywords.

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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