ALLL model validation has gained in emphasis and importance due to advances associated with new technology used to determine the ALLL, as a result of the banking crisis and in preparation of moving to an expected loss accounting model.
Can you have a valid model and still fail an audit? Yes.
- A wrong decision could be made based on poor data.
- The model or its results could be misapplied.
- A lack of trust in the output leads to a delayed decision.
- Missing or inaccurate information could lead to an invalid estimate.
The model validation process includes review of:
- Purpose: the reason the model is employed including the intended use of the information extracted from the model
- Inputs: automated and manual inputs as well as documented and undocumented
assumptions used to create the model, including compliance requirements
- Transformation: formulas used to transform data into information used to manage the activity
- Outputs: the presentation of the information and the ability to interpret the results in a consistent fashion
Correlation is key to a valid model: how well the data correlates to the selected targets – national, local, peers – and the period of time being measured. A leading correlation is ALLL to total assets, funding compared to total charge-offs. Some models don’t look back far enough to demonstrate that information is handled accurately.
Common problems discovered during model validations:
- Growing banks challenged by Excel models
- Lack of project plans for converting to software
- Too much reliance on software vendors for knowledge
- Lack of a transition plan to a new model
- Accounting for acquired loans
- Lack of documented procedures
Keys to model risk management:
- Establish an inventory of all models and rank by impact on the organization.
- Formally explain why the model was created or purchased, and what the intended use of the model is, including if results are used as inputs into another model.
- Determine how the model is used in decision-making and management.
- Document to determine the likelihood of a negative event.
- Ensure IT standards are maintained.
- The banking crisis will continue to define approaches to the ALLL into the future.
- The roles of capital and provision will become better defined.