A Novel Approach to Quantification of Model Risk for Practitioners

Z. Krajčovičová, P. P. Pérez Velasco, C. Vázquez: Models continue to increase their already broad use across industry as well as their sophistication. Worldwide regulation oblige financial institutions to manage and address model risk with the same severity as any other type of risk, e.g. Federal Reserve (SR 11–7) (2011), which besides defines model risk as the potential for adverse consequences from decisions based on incorrect and misused model outputs and reports. Model risk quantification is essential not only in meeting these requirements but for institution’s basic internal operative. It is however a complex task as any comprehensive quantification methodology should at least consider the data used for building the model, its mathematical foundations, the IT infrastructure, overall performance and (most importantly) usage. Besides, the current amount of models and different mathematical modelling techniques is overwhelming. Our proposal is to define quantification of model risk as a calculation of the norm of some appropriate function that belongs to a Banach space, defined over a weighted Riemannian manifold endowed with the Fisher–Rao metric. The aim of the present contribution is twofold: Introduce a sufficiently general and sound mathematical framework to cover the aforementioned points and illustrate how a practitioner may identify the relevant abstract concepts and put them to work.