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Model validation and model risk: reaching the end of the line?

Author

Listed:
  • Michael Thaden

    (International School of Management)

  • Carsten S. Wehn

    (DekaBank)

Abstract

In this paper, we argue that the current standard process of model validation can itself be seen as a model and that the quantification of model risk is very often built upon additional assumptions, which results into an infinite regress. Therefore, model validation in its current form does not constitute an endpoint of the critical examination of all models in use by a financial institution. We will show what this observation means for model uncertainty, validation and model selection. Finally, we make suggestions how this infinite regress could be resolved. In the light of our findings, we recommend a more qualitative judgement of remaining model uncertainties with regard to the regulatory and supervisory point of view rather than the introduction of more complexity into the model risk process.

Suggested Citation

  • Michael Thaden & Carsten S. Wehn, 2020. "Model validation and model risk: reaching the end of the line?," Journal of Banking Regulation, Palgrave Macmillan, vol. 21(4), pages 382-394, December.
    • Handle: RePEc:pal:jbkreg:v:21:y:2020:i:4:d:10.1057_s41261-019-00121-0
    DOI: 10.1057/s41261-019-00121-0
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    References listed on IDEAS

    as
    1. Rama Cont, 2006. "Model Uncertainty And Its Impact On The Pricing Of Derivative Instruments," Mathematical Finance, Wiley Blackwell, vol. 16(3), pages 519-547, July.
    2. Rama Cont, 2006. "Model uncertainty and its impact on the pricing of derivative instruments," Post-Print halshs-00002695, HAL.
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    Cited by:

    1. Cosma, Simona & Rimo, Giuseppe & Torluccio, Giuseppe, 2023. "Knowledge mapping of model risk in banking," International Review of Financial Analysis, Elsevier, vol. 89(C).

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    More about this item

    Keywords

    Model uncertainty; Model risk; Internal governance;
    All these keywords.

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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