Model Risk and the Great Financial Crisis: The Rise of Modern Model Risk Management

Abstract

We trace the development of model risk management in U.S. banking against the backdrop of the growing importance of complex financial models in banks, the recognition of model risk, the emergence of model validation as a response to model risk, and the contribution of failures in model risk management to the Great Financial Crisis. We recognize that while substantial progress has been made in the management of model risk, the challenges have grown, including the increasing reliance by the regulators on models.

Keywords: commercial banks, risk management, systemic risk

JEL Classification: G12, G21