Model Regulation, Post Credit Crisis – Nom de Plumber’s Thought of the Day

ndp  Nom de Plumber is a Nom de Plume.

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Regulator-mandated model controls are now so broadly stringent…..perhaps suppressing helpful cost-benefit trade-offs, independent ad-hoc judgment, or market practicality.

Until recent prescriptives, the validation scope would be only those models whose outputs
feed directly into reports for external constituents (regulators, auditors, investors, lenders).  If the front or back office built a model for discretionary and strictly internal analysis, but not mandatory for outside financial representations, it would not warrant validation. 
Model governance had rested on one key criterion: material relevance to accurate, transparent disclosure.

This boundary line of reasonableness has been erased, or at least greatly blurred.  Virtually every model must now validated.  This expanded compliance burden can inadvertently discourage the creative, trial-and-error analytical exploration which fosters innovation, growth, productivity, and even prudent risk management.  

Think of those on-the-fly models which some risk managers had urgently created for:

1. Restricting the ABS CDO warehouse in 2007 at one whale-sized bank, which then largely avoided 2008 ABS CDO losses
2. Alerting top management at one UK bank in 2007 about excessive super-senior credit exposure, before its 2008 collapse
3. Analyzing the risks and optimal workouts of complex Maiden Lane assets.

In this new world of model governance, none of them would have been allowed for critical immediate decision-making until formally validated beforehand, ironically putting institutions at more, not less, risk. 
 
Thank you.  

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