Internal Audit’s Role in Model Risk Management for Banks

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The internal audit function within a bank is pivotal in assessing the effectiveness of the Model Risk Management (MRM) framework. 

The third line of defense, internal audit, provides independent assurance on the effectiveness of governance, risk management, and internal controls. In the context of MRM, this involves a thorough evaluation of model development, validation, and usage processes.

The Comprehensive Role of Internal Audit in Model Risk Management

Internal audit’s role is to ensure that the MRM framework addresses both types of model risk as described in SR 11/7, for individual models and in aggregate. Internal audit does not duplicate MRM activities but evaluates the framework’s comprehensiveness, rigor, and effectiveness.

Key Responsibilities:

  • Documentation and Reporting: Findings related to models should be documented and reported to the board or its delegated agent.
  • Incentives and Skills: Ensure that internal audit operates with proper incentives, has appropriate skills, and adequate stature within the organization.
  • Expertise: Audit staff should possess expertise in relevant modeling concepts and their application in business lines.

Internal Audit Responsibilities in Model Risk Management

Internal audit must verify that acceptable policies are in place and that model owners and control groups comply with these policies. It should confirm that model use and validation records are accurate and that validations are performed in a timely manner. Additionally, it must ensure that models are subject to controls that account for any weaknesses in validation activities. 

The accuracy and completeness of the model inventory should be assessed, along with processes for establishing and monitoring limits on model usage. Internal audit should determine whether procedures for updating models are clearly documented and test whether these procedures are being carried out as specified. Furthermore, it should check that model owners and control groups meet documentation standards, including risk reporting, and perform assessments of supporting operational systems to evaluate the reliability of data used by models.

Internal audit also plays a critical role in ensuring that validation work is conducted properly and that appropriate effective challenge is being carried out. This involves evaluating the objectivity, competence, and organizational standing of key validation participants to ascertain whether they have the right incentives to discover and report deficiencies. Internal audit should review validation activities conducted by both internal and external parties with the same rigor to ensure they are conducted in accordance with established guidance.

 


 


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