Today, the Bank for International Settlements (BIS) released a report entitled “Developments in Modeling Risk Aggregation,” which addresses improvements to the current modeling techniques used by financial services companies to aggregate and evaluate risks.
The report makes certain findings regarding the risk aggregate techniques used by firms in the financial industry, among them:
- Outdated Models: Despite advances, some firms have not adapted their risk modeling techniques, resulting in models that do not accurately reflect the risks they face, including “tail events,” or unusual or extreme events that, if they occurred, could potentially result in catastrophic consequences. In some instances, the firms are not even addressing the possibility of the occurrence of these tail events.
- Data Mining: Firms face a large amount of data to review and incorporate into the model. Firms are not adequately reassessing or reviewing how the data are incorporated into or communicated by their models.
- Incomplete: Firms often consider their models to be “works in progress” with best practices yet to be established, yet rely on these models as an indicator of risk.
The report makes the following recommendations:
- Firms should reassess and if necessary re models according to the form and function to better understand risks posed.
- If a firm is using a model for risk identification and modeling, it should be examined to ensure that it is sufficiently sensitive, granular, flexible and clear. This is especially true for models for capital adequacy and solvency, which should incorporate the possibility of tail events.
- Firms should ensure that regulatory supervisors are aware of the limitations of their existing models while understanding the benefits of appropriately calibrated and well-functioning aggregation models to improve decision-making processes.