Aligning the economic capital of model risk with the strategic objectives of an enterprise

Abstract

Enterprise risk management is a method for managing risks associated with strategic objectives of an organisation. Enterprise risk management is designed to identify potential risks affecting the organisation and to manage risks within the organisations risk appetite. In the financial industry, there exist relationships between setting objectives, using models to set the desired risk appetite threshold, setting aside capital, and complying with the law. Financial service providers rely constantly on financial models due to the products and services that they provide to their customers. Relying constantly on models may present model risk which may have a negative impact on the daily operations of a financial service provider. Financial crises may as well increase model risk because many models stop to function as usual after a financial crisis; and the model outputs become unreliable. Model developers often change the parameters of the model after the financial crisis without following the entire model development process. This behaviour may escalate model risk. In this study, we argue that to manage the model risk effectively, complete model development and validation processes should be followed when redeveloping the existing model or when developing a new model. A theoretical framework on model risk management is developed based on a synthesis of both the theoretical and empirical studies conducted. A financial model performs better if it satisfies all the characteristics of the existing market conditions. For example, during a stable low-volatility market condition a model should incorporate all the factors that are driving the market to be stable; and similarly during a more unstable high-volatility state market condition a model should also incorporate all the factors that are driving the market to be unstable. Markets change all the time and some markets create market cycles in a long run. To deal with unexpected losses, banks should reserve economic capital, which is defined as the excessive loss level that the enterprise can tolerate to ensure its survival with a certain confidence level. The economic capital should be adjusted to align it with the existing generic strategy of the bank in order to reserve an adequate amount of economic capital and to manage it optimally. The study attempts to estimate the enterprise's economic capital of a financial model. In this study, the economic capital is aligned with the enterprise's generic strategy in order to prepare the organisation for unexpected events that may harm the organisation's survival.