Opportunities and risks go hand in hand for businesses. When tapped effectively, opportunities can help businesses garner various gains. These include improving their position in the market, increasing market competitiveness against rival businesses, and boosting revenue growth. In comparison to the opportunities, risks can bring losses to businesses in various ways. These include decreased production output, reduced quality of their products, loss of capital, investment, or revenue, loss of data, etc. Other risks can be loss of business reputation among customers, and investors, and lack of trust, including regulatory compliance failures could damage the integrity of an organization.
To reduce the impact of risks on various aspects of your business, businesses can utilize internal audits for risk assessment, identification, and mitigation. Internal audits can be performed by a team of in-house financial experts, or an outside financial consulting firm. It is preferable to have a third-party consulting firm evaluate the models being used for compliance purposes by a bank – to ensure that models are used for their intended purposes. Third-party consultants can assess the models from multiple dimensions – thereby adding value to the bank whose models are being audited. Not only would they perform independent audits, but they would also create unbiased audit reports – which is essential for compliance and regulatory purposes.
However, to assess and identify the risks to a business, internal auditors must refer to and analyze various types of models such as those used for liquidity, market rate, mortgage lending, stress testing, and comprehensive capital analysis and review (CCAR) purposes. By definition, a model is a real-world representation of a given phenomenon. Put differently, a model uses quantitative and mathematical approaches to process data input, based on certain assumptions to derive an outcome. Model outputs are used for various decision-making processes by banks, and other financial institutions.
The models used for risk assessment, classification, and identification in a business are known as Risk Management Models. Risk managers and quantitative analysts build these models to serve as internal guidance for business operations. For example, your business may use hundreds to thousands of variables depending on the complexity and requirements of the type of model being developed.
Additionally, there can be instances where financial experts cannot rightfully assess the risks while studying these models. It is known as model risk. It occurs due to one of these two reasons. Firstly, the model is not used for its intended purpose, and/or poor implementation of a model. Secondly, there are theoretical or implementation errors in the model. A model may not be a good fit due to model developers using wrong assumptions while constructing the model. Statistical biases can also lead to the construction of wrong models. Erroneous implementation of models may result from financial analysts having an inaccurate understanding of a model and the factors associated with it.
The context in which models are applied may change due to market dynamics. Using the wrong models and applying the right model to the wrong context; can lead to errors in identifying and assessing risks. These errors can prove damaging to the business in various ways. They can cause businesses considerable monetary losses, which may have long-term implications such as affecting the quality of their organizational decision-making and leading to loss of reputation – especially among customers, investors, and other stakeholders. Financial experts must perform model validation and model risk management for a business prudently to avoid such undesired scenarios.
The model risk management process conducted for a business revolves around these four key points: –
Model risk identification and assessment
Model risk governance
Model risk validation
Model monitoring and reporting.
Model risk identification and assessment
Model risk identification and assessment is a process that helps find model validators and internal auditors assess the risks arising due to a business choosing the wrong risk management framework or using the right risk management model in the wrong context. Only when these risks are effectively identified and assessed, then can the business take the necessary steps for managing, mitigating, and resolving such risks.
Model risk governance
In the model risk governance process, a business organization controls access, implements policy, and tracks activity for models and their results. The financial experts performing the internal audit for an organization provide useful insights and suggestions for the improvement of the governance framework – which is often lacking within most Model Risk Management (MRM) Groups.
Model risk validation phases
In the model risk validation phases, certain processes and activities are performed to verify that models perform as expected and align with their design objectives and business uses of the model. Here an independent review is conducted by financial specialists. They check the objectives, assumptions, data, and performance outcomes such as benchmark and backtesting analysis of the model. The model risk validation process effectively challenges each model’s development, implementation, and use. The internal audit team plays a key role in performing various activities related to the model risk validation process. Model validation enables them to identify key weaknesses and limitations of a model, so it can be improved and adapted towards model implementation. While model validation is just a part of various tasks performed by the team of financial experts, internal audit is the whole process undertaken by the experts in identifying and managing the risks faced by a business.
Model monitoring and reporting.
Model monitoring aims to verify whether a business organization complies with the regulatory requirements for its internal models. Financial experts of a competent authority produce the model monitoring report based on the internal audit performed by them – to capture the performance of a given risk model.
The experts will use the latest techniques and technologies, like Artificial Intelligence (AI) and Machine Learning (ML) to efficiently gather and assess the data and the various variables associated with these models. They will also use manual techniques and sources for gathering the data. By assessing and analyzing the data, model validators can obtain deep insights from data that will prove beneficial for businesses. Their insights would help assess, identify, and mitigate risks and avoid losses if these risks went undetected. Also, model validation will provide recommendations for model improvement to guide managers in making informed decisions.
Therefore, an internal audit performed by a financial advisory firm’s experts can enable your business to assess the accuracy of various risk management models and their implications. Also, the audit will help avoid any financial and other losses arising from implementing and assessing wrong models. By evaluating the business’s internal controls, including governance and accounting processes, internal auditors play a crucial role in identifying sources of model risk for an organization.
Does your business also want to resolve the problem of getting faulty insights from implementing and assessing wrong risk management models and avoid losses because of them? Then go with a tried, tested, financial advisory consulting firm like Leka Research Institute. Its experts have the necessary experience, expertise, and financial industry knowledge. Also, they have access to the latest data analytical tools and technologies like ML and AI to help companies identify risk.
So, you can rely on them to perform a perfect internal audit for your business – through proper identification of the risks to your organization, as well as proposing solutions to mitigate your business risks. As a result, your organization can make the right and business-benefiting decisions. Also, your organization can continue to move on the path of growth and success with confidence, satisfactorily fulfilling the expectations and needs of its customers, investors, and other stakeholders and achieving its business goals.
To begin your internal audit journey and navigate it to success, call our experts today at +1(855)-558-4774 or email info@lekaresearchinstitute.com.