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Answer: Perform sensitivity analysis on all models used by the bank to identify market conditions under which they might perform poorly.
**D is correct.** Sensitivity analysis and other checks for the robustness and stability of a model should be repeated periodically. This analysis can help assess the model's performance given a wide range of market conditions and identify those conditions (such as interest rate or financial market environments) in which the model might not perform as effectively and therefore its use should be constrained under these conditions. **A is incorrect.** Even a fundamentally sound model producing accurate outputs consistent with the design objective of the model may exhibit high model risk if it is misapplied or misused. Applying a residential mortgage model to a commercial loan product would be an example of misapplication. **B is incorrect.** Best practices do not preclude the inclusion of qualitative or judgmental aspects of models. In some cases, banks may take statistical output from a model and modify it with judgmental or qualitative adjustments as part of their model development process. While such practices may be appropriate, banks should ensure that any such adjustments made as part of the development process are conducted in an appropriate and systematic manner, and are well documented. **C is incorrect.** Validation should be performed by parties who are independent of the model development team to avoid conflicts of interest.
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A midsize bank specializing in residential mortgages and credit cards is planning to offer a new commercial loan product. The bank has an existing credit rating model for its residential mortgage products which has performed well and has been successfully backtested over several years, but the CRO considers whether the bank should develop and implement a new model for the commercial loan product. In addition, the CRO wants to ensure that the bank follows best practices for the development, validation, and implementation of any models that it uses. Which of the following actions should the CRO recommend that the bank take?
A
Apply the strongly performing existing model to the new commercial loan product given the model's successful track record.
B
Develop a new model for the commercial loan product and avoid the use of qualitative or judgmental adjustments to the model's quantitative output.
C
Make the model development team responsible for validating all of the bank's models that are currently operational.
D
Perform sensitivity analysis on all models used by the bank to identify market conditions under which they might perform poorly.