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Answer: Both statements are correct
## Explanation Both statements represent significant sources of model risk: **Statement I**: This creates a **conflict of interest** and **incentive misalignment**. When IRO staff compensation depends on model usage frequency, it creates pressure to approve models quickly or be less rigorous in validation to ensure higher usage. This undermines the independence and objectivity required for proper model risk management. **Statement II**: Assuming perfectly liquid markets is a **model specification risk**. In reality, markets experience varying degrees of liquidity, especially during stress periods. This assumption can lead to: - Underestimation of transaction costs - Inaccurate pricing during market stress - Failure to capture liquidity risk - Incorrect risk measures Both policies compromise model integrity and reliability, making them sources of model risk that need to be addressed through proper governance and validation frameworks.
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You are the head of the Independent Risk Oversight (IRO) unit of XYZ bank. Your first task is to review the following existing policies relating to model implementation.
I. The remuneration of the staff of the IRO unit is dependent on how frequently the traders of XYZ bank use models vetted by the IRO.
II. Model specifications assume that markets are perfectly liquid.
Which of the existing policies are sources of model risk?
A
Statement I only
B
Statement II only
C
Both statements are correct
D
Both statements are incorrect