A systematic design for coping with model risk

Abstract

Model risk has become an important risk that must be taken into account by financial institutions when they make the strategic-level decision of company’s solvency control and risk management through simulating and analyzing company’s financial situation. To effectively cope with the model risk, the strategic-level simulation system (SSS) that implements the business view and economic environment and generates various useful financial and risk management reports cannot be treated as a static information system. Rather, SSS represents a family of possibilities because the senior manager who performs the simulation has a role in how the simulation is actually carried out. The extent of these variations is likely to increase when the business environment changes, the relevant financial theories evolve, and the senior manager assesses the system flexibility of SSS. Hereby, the system flexibility of SSS means its users, normally the senior manager, can have the luxury of modifying themselves the embedded functions associated with certain risk factors through the (user-friendly) interface. Based upon the guidance of design science, this study proposes a systematical way of designing a SSS that can effectively cope with the model risk. Specifically, this study takes the Dynamic Financial Analysis system as an example to illustrate the proposed system design.