Journal of Applied Finance & Banking

On the Treatment of Model Risk in the Internal Capital Adequacy Assessment Process

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  • Abstract

    Currently, model risk related to risk models is subject of intense discussions between regulators and the banking industry. With regard to increasing requirements on the one hand and yet no standardized approach by banks to handle model risk on the other hand, this article draws the area of conflict by providing a comprehensive definition and delimitation of model risks and the related regulatory requirements. The main focus lies in the systematic treatment of model risk in the context of internal governance and internal capital adequacy, its appropriate assessment or quantification as well as an adequate procedural handling of model risk. The article shows the main different approaches of how to incorporate model risk in the internal risk management and discusses the respective pros and cons.

    JEL classification numbers: C02, G21, G24
    Keywords: Model uncertainty, parameter uncertainty, estimation errors, model risk, internal governance, internal capital adequacy, risk capital