dr. susanne brandenberger head risk control vontobel groupfocus on model risk lessons learnt from...
TRANSCRIPT
The challenge of governing model risk
ETH Risk Day 2013
Dr. Susanne Brandenberger
Head Risk ControlVontobel Group
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Slide 2
Focus on Model Risk
Lessons learnt from financial crisis
� More attention on risk management and model validation in general
� Focus on «mark to model» valuations (IFRS level 2/3 valuations) and independent validation processes for pricing models
� Refinements of «best practices» as well as new regulatory standards
Regime shifts in markets
� Extraordinary high credit spread levels
� Extraordinary low and negative interest rates
Products
� More complex models for same products
� Hybrid products (e.g. autocallables) and difficult to measure input parameters (e.g. correlations)
Accounting Challenges� FVA, DVA, CVA ….
Model Risk in Practice: Valuation of caps and floors with negative interest rates
Starting Point:
Decision by Swiss National Bank to defend a CHF/EUR
FX rate of 1.20 leads to negative par swap rates and overnight rates (TOIS) for
CHF
-> negative forward rates
-> Black76’ model assumes log
normal dynamic of forward rates i.e. negative rates are not possible
-> the market assumes relatively high movements also for very low
rates however; premiums for floors can be substantial
Slide 3
Source: Bloomberg
Par swap rate for 3yr tenor against 3M libor
Model Risk in Practice: Valuation of caps and floors with negative interest rates
ICAP Black76 implied Vol CHF 1Yx3M ATM Cap in
Bloomberg:
-> Volatilities in the Black 76’ Model explode for Options with low strikes and strike «0»
-> Valuation with the Black 76’
Model is not possible given these market parameters
Slide 4
Source: Bloomberg
Model Risk in Practice: Valuation of caps and floors with negative interest rates
Slide 5
Black76 implied Vol Surface EUR 19.4.2013 Displaced Diffusion Vol-Surface EUR 19.4.2013 (Shift 1%)
� Log normal assumption for forward rates is no longer valid in low interest rate environment
� Black76 – model (or any other model based on lognormal assumption) can not be used-> use of normal model or displaced diffusion model (normal SABR)
Source: Calculations by Vontobel
Slide 6
What is Model Risk?
Model Risk =
«The possibility that a financial institution suffers losses due to mistakes in the
development and application of (valuation) models.»
Morini [2011], p. 3
What kind of models?
� Pricing/Valuation/Hedging Models
� Risk Aggregation Models; Regulatory capital models
� Forecasting models, Performance models, …
What kind of losses? - Pricing/Valuation/Hedging Models
� Losses over time due to underestimation of hedging costs e.g. selling optionality at
too low prices
� Losses due to a regime shift in the market and/or in the market consensus on the
«right» model
� P/L hit due to immediate adjustment of mark-to-model valuation caused by failure of internal processes and controls
Slide 7
Pricing and Risk Models
HistoricMarket Data
Positions
Aggregated
RiskReporting
(VaR, Stress)
Scenario-Generator
Instruments
(Static Data)
(Re-)Valuation-Engine
Aggregation-Engine
Actual
Market Data
Models (yield curves,
Volas, …)
Pricing / HedgingModels
Valuations
Hedge Param.
P/L
Reporting
Slide 8
Management and Mitigation of Model Risk
Quality ManagementIndependent Review and
Controls
Model ReservesFair Value Adjustments
Parameter / Price Verifica-
tion (IPV)
Model
Validation
Fair Value =
Theoretical Value + Model Reserve
Model Reserve to cover risk due to• parameter uncertainty
• model risk Analysis of
daily P/L
Analysis of collateral
disputes
Slide 9
Model Validation - Tasks and Responsibilities
Business Unit / Model Owner → «Risk Taker and Fist Line of Defense»
� Responsible for ensuring that models are properly developed, implemented, and
used
� Accountable for model use and performance (within the framework set)
� Model documentation
Risk Control → «Second Line of Defense»
� Responsible for management of independent validation and review process
� Accountable for effective challenge of models and their implementation and use
� Responsible for defining any restrictions and limits on model usage
� Documentation: Model validation reports and inventories
� Responsibility allocated to individuals and committees
Audit → «Third Line of Defense»
� Assessment of overall effectiveness of model risk management framework
Slide 10
Model Validation - Processes
Model Validation and Approval
� Clearly defined multi-stage internal process for implementation of a new or change of anexisting model:
– Qualitative validation: Assumptions and numerics
– Quantitative assessment– Independent benchmarking
� Applicable for vendor as well as proprietary models
� Output of process is approval (yes/no), often with specific requirements for improvements or
restrictions
Approval for «Prototyping»
� Approval for restricted use of proprietary developed models within tight limits and restrictions(products, volumes, …)
� Partial validation and approval procedure
� Only possible for limited time period, at the end of period full validation or withdrawal ofapproval.
Periodic Model Review
� Periodic review of relevant models
� Challenge of identifying «relevant» models, i.e. based on sensitivities (“Greeks”)
Slide 11
Model Validation - Tools
Validation Tools:
� Testing framework
� Benchmark library
“Model Inventory”:
� Short model description
� «Model mapping»: Classification of products with models used to price them
� Restrictions regarding use for certain products
� Documentation and assessment of input parameters
� Developer
� Information on implementation
� Validation approach, date of validation and approval; Open issues and deadlines
� Model documentation as well as model validation documentation.
Periodic Management Reporting:
Statistics on models, volumes and «risk ratings»:
� Full Validation with/without open issues;
� partial validation / “Prototyping”
� Pending validation for certain time periods
Slide 12
Governance - «Effective challenge» of Models
� Definition of tasks and responsibilities
� Allocation of resources needed
� Definition of reporting, control and
escalation procedures
� Definition of internal guidelines regarding organization and processes
→ Incentives; Segregation of duties
→ Competence
→ Influence
Slide 13
References
Basel Committee on Banking Supervision (BC): «Supervisory guidance for assessing banks’ financial instrument
fair value practices», April 2009.
Board of Governors of the Federal Reserve System / Officer of the Comptroller of the Currency (FED):
«Supervisory Guidance on Model Risk Management», April 4, 2011.
Derman, Emanuel: «Markets and models», Risk Magazine, July 2001, p.
Derman, Emanuel: «The Principles and Practice Of Verifying Derivatives Prices», April 2001.
Elices, Alberto; «The role of the Model Validation function to manage and mitigate model risk», November 2, 2012.
Morini, Massimo: «Understanding and Managing Model Risk», Wiley, 2011.
Rebonato, Riccardo: «Theory and Practice of Model Risk Management», Quantitative Research Center (QUARC)
of the Royal Bank of Scotland, 2003.