The Prudential Regulation Authority (PRA) has published a policy statement on its model risk management principles for banks (the Principles) following an earlier consultation paper (CP6/22) on the same subject. The PRA believe the Principles which will assist in the establishment of an effective model risk management framework. The Principles do not apply to credit unions, insurance, and reinsurance firms.
The Principles are:
- Principle 1: Model identification and model risk classification;
- Principle 2: Governance;
- Principle 3: Model development, implementation and use;
- Principle 4: Independent model validation; and
- Principle 5: Model risk mitigants.
The PRA believes that the Principles are in line with similar expectations by other global regulators.
Following the feedback received to the consultation, the PRA intends to make the following key changes to the proposals before implementation:
- Senior Management Function (SMF) accountability – the PRA has modified the wording of Principle 2.2 to remove potential ambiguity in responsibilities of the SMF and clarify that more than one SMF may be appointed;
- financial reporting – the PRA has replaced a reference to accounting with financial reporting and clarified the intent is to ensure MRM reporting is available to the audit committee;
- model tiering – the PRA has modified the wording in Principle 1.3 (c) to clarify that firms can select the relevant factors to determine model complexity;
- subsidiaries – the PRA has clarified that subsidiaries using models developed by their parent-group may leverage the outcome of the group’s validation of the model if the conditions in Principle 2.6 (c) are satisfied;
- dynamic recalibration – the PRA has combined the expectation for models that recalibrate dynamically in (former) Principle 3.3 (d) with the (former) clause on model changes in Principle 3.3 (e);
- model documentation for vendor models – the PRA has clarified the expectation for model documentation of vendor models in Principle 3.5;
- post model adjustments – the PRA has modified the principle on model adjustments (Principle 3.4) to acknowledge that model adjustments are an important risk management tool, and changes have been made to Principle 5.1 to recognise the need for proportionality; and
- escalation processes – the PRA has modified Principle 5.3 to be less prescriptive and more principles-based in line with CP6/22’s intent.
The policy will take effect on Friday 17 May 2024. Firms that first receive permission to use an internal model to calculate regulatory capital after the publication of the policy will have 12 months from the grant of that permission to comply with the expectations in SS1/23.