Major Market Participants Still Struggling to Streamline Process

A movement by financial institutions and regulators to develop standardized processes and technology for managing the risk associated with sophisticated financial models would lower costs and potentially reduce systemic risk, according to a new report from Greenwich Associates.

The report, entitled Reducing the Risk of Using Financial Models, analyzes the techniques used by banks and other financial institutions to quantify and manage the risk associated with the use of increasingly complex financial models.

Model risk management became a priority for financial institutions in the wake of the global financial crisis. Guidelines from the U.S. Federal Reserve Bank spell out a general process financial institutions must use to develop, validate and monitor financial models. “The biggest model risk is the one you don’t know exists,” says Kevin McPartland, Head of Market Structure and Technology Research at Greenwich Associates.

However, the Fed guidelines provide only a limited description of requirements and do not provide a direct use of technology as part of the model risk management process—a remarkable omission given the technical nature of the risk being monitored.

Greenwich Associates has learned that financial institutions have developed robust processes that meet both the letter and the spirit of the rules. However, many of these processes are far from automated, requiring approvals to be noted manually in internally developed databases, with no automatic prompting to ensure the next step in the process is completed.

While the general trend in financial services IT is toward outsourced technology, many model risk management processes are run via internally developed software. Greenwich Associates sees this approach as short-sighted and advises financial institutions be more strategic and employ an enterprise software solution to streamline and simplify the model risk management process.

“While financial models are certainly part of the secret sauce that drives profits on both the buy side and sell side, the management of risks associated with these models is universal problem screaming for a streamlined solution that could benefit all by lowering costs and potentially, systemic risk,” McPartland says.