Model risk management: from epistemology to corporate governance

One of the main concerns and regulatory topics that financial institutions have to deal with is model risk. Senior managers are increasingly considering model risk to be one of the most severe vulnerabilities to which a financial institution can be exposed. While the concept seems relatively simple, the definition of model risk (both traditional and regulatory), its origins (from dogma to misuse) and ways to manage it (from engineering conservatism into models to having a proper governance process) are not necessarily handled well by practitioners, academics and regulators. Having a clear definition of model failure and understanding its root causes allow us to adopt the appropriate management style to deal with potential issues that could lead to dramatic failures. In this paper, we conduct an analysis of model risk in an attempt to understand the main issues that lead to failures and the best way to address such issues.