Model Validation Standards

Soft Launch

Effective from Dec 28 2022 - Dec 31 2022
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Banks must maintain a process to ensure that their internal models have been adequately validated by suitably qualified parties independent of the model development process to ensure that each model is conceptually sound and adequately reflects all material risks. Model validation must be conducted both when the model is initially developed and when any significant changes are made to the model. The bank must revalidate its models periodically, particularly when there have been significant structural changes in the market or changes to the composition of the bank’s portfolio that might lead to the models no longer being adequate. Model validation must include PLA and backtesting, and must, at a minimum, also include the following:

Tests to demonstrate that any assumptions made within internal models are appropriate and do not underestimate risk. This may include reviewing the appropriateness of assumptions of normal distributions and any pricing models.

Further to the regulatory backtesting programmes, model validation must assess the hypothetical P&L (HPL) calculation methodology.

The bank must use hypothetical portfolios to ensure that internal models are able to account for particular structural features that may arise. For example, where the data history for a particular instrument does not meet the quantitative standards in [13.1] to [13.12] and the bank maps these positions to proxies, the bank must ensure that the proxies produce conservative results under relevant market scenarios, with sufficient consideration given to ensuring:

that material basis risks are adequately reflected (including mismatches between long and short positions by maturity or by issuer); and

that the models reflect concentration risk that may arise in an undiversified portfolio.