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Model Risk Management

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Model risk involves the use of financial models, and the potential that errors in setup, input, or interpretation of results can lead to material misstatement of results. Model risk can be present in internally created financial models or in vendor-supplied financial models and/or results.

Having a model’s mathematics validated periodically (important only if there is a change to the underlying software and/or application of the software) can be one way to reduce model risk. However, what about errors in the setup, data input, or interpretation of results? Beyond periodic, formal written model validations, how can decision-makers limit their exposure to model risk? Below are some key items that those involved in financial modeling should consider to aid in reducing model risk:

  • Ensure a clean audit trail for model assumptions. Whether modeling internally or engaging an outside third party to conduct modeling, key assumptions utilized (e.g., deposit pricing, prepayment speed, principal cash flows) should be easily available for review by decision-makers. Key assumptions regarding credit/default risk, interest rate environments modeled, and market rates that drive model results should be well-documented and available for review.
  • Automated does not mean “error free.” Even though many aspects of financial modeling now include a high degree of automation, ensuring that the automated inputs for financial models are being appropriately captured by the model is the first step in automation being a benefit, and not a drawback, in the financial modeling process. Additionally, if there are any new products added or changes made to existing products, those responsible for the modeling/report generation should be made aware of the changes.
  • Separation of duties. Is there sufficient separation between those taking risks (e.g., treasury, investment department or advisor, loan department, etc.) and those reporting risks? An independent third party unaffiliated with investment activity for the credit union (whether both functions occur within or outside the credit union) can be a strong control in the modeling process. The modeler should be encouraged to independently test the risk, including stressing vulnerability to expectations not coming true.
  • Modeling risk vs. plans. Planning what you expect to happen is typically opposite of the risk if things go wrong. As a result, a key part of avoiding modeling risk is ensuring that the modeling is addressing things that can go wrong, such as deposits migrating from low-cost accounts, loan balances decreasing, and credit risk increasing.
  • Apply common sense. Step back and evaluate whether the results make sense. In our experience of performing model validations, it is common to see extremely optimistic deposit values that are far beyond any price an institution would actually pay to acquire the deposits. Another example is the modeling showing huge gains on the portfolio, while the institution states that its loan rates are very competitive and the loan growth is above market. Results along these lines should raise flags about the exposure to the risk results being wrong, or if the institution feels the results are correct, additional explanation should be available.

Financial modeling should provide decision-makers with useful and relevant information to aid in the decision-making process. Ensuring that a robust system for mitigating model risk exists can help ensure the reliability of that information.

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Project Management Tip #4: The Dependencies

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When building a project plan, the timeline and budget will require close attention to the dependencies in the plan, and how they can affect the success of the project. For instance, a project to implement new software could be dependent on first ordering hardware and waiting for it to arrive, or the successful testing of the software to validate that the project goals are being met. Every time a task has dependencies for completion, the timing to complete those dependencies must be factored into the plan. When figuring out how much completion time to assign for a dependency, try to factor in the variables that are not in the credit union’s control, and how they could impact the project’s timing and budget.

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COMPARISON OF INTEREST RATE RISK METHODOLOGIES

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Interest rate risk was originally viewed as a process that should be done in a back room, resulting in volumes of information that was stored on a shelf to be available when examiners walked in. However, the complexity of the world has changed over time and so must the use of tools to help evaluate the trade-offs of decisions being faced. Institutions need to ensure they are getting answers to the right business questions in order to create a solid foundation that links strategy and desired financial performance. While there are many aspects to creating strong and sustainable financial performance, this article focuses on the abilities of the primary interest rate risk (IRR) methodologies to support decision-making.

This article was originally published as a Financial Flash by the CUNA CFO Council. The full article (Comparison of Interest Rate Risk Methodologies) can be found here.

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Considering New Systems? How to Improve Chances for Success

Many credit union management teams are considering changes to their mobile platform, home banking, loan origination system (LOS) and/or account opening system (AOS).  The following are just a few (of many) tips to consider:

  • Get clarity before submitting RFPs.  As a leadership team, agree on your decision drivers and the specific business objectives you are trying to achieve
  • Sort out the “must haves” versus the “nice to haves” and reach consensus as a leadership team
  • Document your agreements and rationale—people are overloaded and memories can be fuzzy and short
  • Map the ideal process.  It is invaluable to map the ideal process as part of your discovery.  It helps teams clarify objectives and sort out priorities before submitting RFPs
  • Remember, the IT department is only a fraction of the resources that will be needed on these types of endeavors.  Many departments will be involved so be sure to identify the resources needed for each (think of testing, training, marketing, compliance, etc.)
  • There is no perfect system.  Choices and sacrifices will have to be made.  When faced with these decisions, always go back to your decision drivers and business objectives
  • As the saying goes, don’t pave the cow’s path!  It’s surprising how many businesses spend tons of time and money implementing slick new technology, only to follow the same processes used with the previous system
  • Before pulling the trigger, agree on other projects that will be put on hold.  Again, document your agreements and rationale (memories are fuzzy and short!)
  • Have a rigorous process to sort through the many times you will hear or think, “wouldn’t it be cool if…?”  Technology is often filled with good intentions of using all the cool bells and whistles.  Yet for many, the only people that know about the cool features are the people in IT who installed the technology.  If you get bells and whistles, don’t forget to develop plans to tout them to your employees and members
  • Have a Senior Executive Sponsor who clearly understands the credit union’s strategy, business objectives and priorities who is involved in both discovery and implementation

Installing a new home banking, LOS or AOS is a venture that should not be taken lightly.  There is more on the line than just a successful implementation—the credit union’s reputation could ultimately be at stake.  It will be critical to weigh and measure every decision with the gravitas these projects deserve.

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Proposed Interest Rate Risk Regulation

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Newly proposed regulations would require federally insured credit unions to not only have an effective interest rate risk management program, but also a written policy addressing interest rate risk management.  The NCUA has taken this step due to concerns about the level of interest rate risk being taken by many institutions, as material concentrations in long-term, fixed-rate assets continue to be booked in this historically low rate environment—funded largely by short-term deposits.

Most often, managements and boards establish limits at the category or portfolio level, not at the enterprise/aggregate level.  It is not uncommon to see a credit union within their individual category or portfolio levels, yet have a relatively high level of risk at the enterprise level.  In other words, the combination of the individual risks can create an undesirable, aggregate risk profile.  Therefore, agreeing on and managing to aggregate risk levels is a key component of an effective risk management process.  However, establishing aggregate risk limits that make sense from a business perspective, as well as from a safety and soundness perspective, requires in-depth discussions and critical thinking.

These limits can also be a critical driver of financial success both today and as rates change.  So take your time and think it through.

While we believe it is prudent for decision makers to establish enterprise/aggregate risk limits, it is not intended as an endorsement for the proposed regulation.  We will write more on the proposed regulation soon.

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