In an ever-changing world, even minuscule developments in the social, political, or digital atmosphere can have big impacts on all enterprises. The financial systems of today are no different, as they are enterprises that thrive on building globalized linkages with people and nations. Consequently, a threat faced by one financial institution can become a cause for serious uncertainty and risks to the worldwide economy.
For instance, take the global financial crisis of 2008, where threats to a financial system were multi-layered and invasive enough to cause unprecedented damage for all players. It proved hazardous for the US banking system to begin with, but also dashed the dreams of millions of common people, investors, and developing institutions. In hindsight, it has provided us with important insights into how to assess, mitigate, and plan for the containment of risks inherent in international banking and valuation systems.
Today’s traditional risk management practices are insufficient for preventing the impairment of economic mechanisms across the globe. We need a system that uses past knowledge and ongoing developments to create more comprehensive risk management models. This is where contemporary models of Enterprise Risk Management (ERM) come in. This blog post explores the most relevant models and digital tools needed to mitigate risks for the financial institutions of today, while also preparing them for the future!
- Identification
This refers to the process of assessing the internal and external atmosphere of an institution to spot potential risks. A catalog of activities the financial institution engages in is examined to quantify and categorize all possible threats to its operations. The data collected is analyzed to build risk models that functionalize a firm’s risk management strategy.
- Assessment
Once we are aware of the potential risks, it is imperative to assess their likelihood and the financial impact they could have on an institution. Both, direct risks such as natural disasters, and indirect or residual risks of a firm’s own activities are mapped. These are then fit into a categorical ERM framework, which predicts their occurrence rates and potential damage. Next, a strategy is formulated to provide a suitable response in the event such a risk does arise.
- Management
This includes action plans focused on controlling, preventing, and mitigating risks in an institution. A detailed list of actions is defined to communicate priorities, assign responsibilities, and offer defensive measures against a probable threat. Continuous data gathering, monitoring, and predictive analysis of control responses is also a part of the risk management framework.
ERM frameworks often rely on risk models that utilize both quantitative techniques and machine learning algorithms. Yet any failures or miscalculations of a risk model arising from faulty modeling can cause acute damage to the operational processes of a company. This is where Model Risk Management becomes a crucial strategy that needs to be incorporated into all ERM plans. Let’s look into it in more detail.
Cost savings
MRM improves process efficiency in model development and validation while taking inventory of risky operative practices that can be eliminated in time. As we know, an ounce of prevention is worth a pound of cure, and MRM proves to be useful in nipping defective models in the bud. This improves the chances of operational success at all levels, and minimizes the possibility of financial losses for a firm. This creates significant cost savings while meeting institutional objectives safely and quickly.
Compliance
Model risk management helps in anticipating and mitigating potential model failures before they happen. This results in better consistency in operations and smoother governance of the firm. A well-managed financial institution stays in a position where it can address problems and setbacks at the earliest, leading to the harmonious functioning of its activities. Such an enterprise can thus stay compliant with regulatory standards like the SR 11-7 and SS1/23.
Better decision-making
Model risk management allows organizations to potentially employ the best-ranking and thoroughly researched models for their enterprises. Proper validation allows relevant stakeholders to use systematically tested models for governance and policy execution, resulting in greater transparency and trust. This promotes better judgment and decision-making throughout the firm.
