Our clients are facing three primary issues when it comes to regulatory compliance:
Many are facing Matters Requiring Attention (MRA) and Matters Requiring Immediate Attention (MRIA) and don’t have the staff or the capacity to complete all of the work themselves within tight deadlines. They also want their limited resources to work on internal, proprietary initiatives to grow the business and maximize profit and return. These activities cannot be outsourced as easily as regulatory and compliance work, which is relatively easy to parse out and give to an external third party. Quite often, a level of independent oversight and effective challenge is also a requirement that can easily be solved through the use of an objective, external third party.
A lot of the regulations are still relatively new, and there are still many issues and knowledge gaps our clients are facing. They have insight into their own organization only and quite often aren’t aware of or able to leverage industry best practice without the view of an external third party with broader industry knowledge and experience.
In terms of best practice, it all really starts with the data, leading to the attributes used in models to create sound risk management strategies, manage capital adequacy, and ensure the safety and soundness of the overall U.S. and global financial system. The integrity of data reporting, dispute management and compliance with all applicable regulatory requirements need to be an enterprise-wide effort.
In the area of attribute governance, there are three primary areas of focus:
- Attribution creation — definitions; logic, code and accuracy; and how to reduce implementation timelines.
- Monitoring and maintenance — looking for shifts in attributes and their potential impact and facilitating updates to attributes based upon changes in reporting and upgrades to newer versions of attributes as the credit environment changes, such as during the most recent mortgage crisis, where loan modification and associated attributes were created and took on increased importance.
- And last but definitely not least, documentation — We cannot say enough about the importance of documentation, especially to regulators. Documentation ensures accuracy and consistent application and must record all general conventions and limitations.
For model risk management and governance, focus areas should follow the expanded Office of the Comptroller of the Currency (OCC) Guidance from Bulletin 2011-12. This guidance includes expanded requirements for model validations including not just standard back testing, but also benchmarking, effective challenge, sensitivity analysis and stress testing. It also expands the guidance beyond just validation to model development and usage, implementation, governance and controls.
In response to these OCC expanded guidance requirements, one of our clients was seeking an industry expert to serve as an independent third party to 1) conduct industry best practice and benchmarking in areas of reject inference methodologies and 2) validate production models used for risk underwriting, line assignment, pricing and targeting.
After a full review and assessment, we provided the client with a clear road map to improve the process to conduct reject inference through knowledge transfer and best practices. We established a best-in-class approach to annual model validations on a model inventory consisting of retail, small business and wealth segment portfolios. We also delivered expedited results that also identified alternative methods of validation that assess variability in point estimates, as well as comply with OCC requirements for precision, ranking and population measurement statistics.
Through our work, the client was able to leverage Experian to establish a global approach to reject inference methodologies, to augment existing staffing and to offshore resources in a cost-effective manner.
There are three primary areas of loss forecasting, stress testing and capital adequacy planning:
- International — Basel accord
- National — U.S. Dodd-Frank Act Stress Testing (DFAST), including Comprehensive Capital Analysis and Review (CCAR) supervisory review
- Internal — Allowance for Loan and Lease Losses requirements
Although there are similarities, there are also important differences among each of these three requirements and practices. For these reasons, most financial institutions in the United States are still providing and managing them separately. This obviously creates a strain on internal staff and resources.
One of our clients had an initial compliance strategy in place but did not have the sufficient in-house staff and resources required to create, document and review its modeling and stress testing to satisfy regulators and internal auditors. The organization needed a consultant that could work closely with its in-house team to support sophisticated models that were tailored to meet its specific compliance obligations.
We worked closely with the client’s team to provide extensive consulting support for a complex set of loss-forecasting models and other tools, applying industry best practices to fully document the models. Throughout the process, our consulting team discovered and identified content gaps to help ensure that all documentation was complete. We also provided ad hoc analytics to support the client’s model development effort and strategic and tactical guidance on stress testing model development for compliance.
This enabled the client to develop primary and challenge models for DFAST’s CCAR requirements, as well as internal stress scenarios. It also provided the client with the following tangible business benefits: balance compliance with maximum profitability and revenue; provided knowledge sharing and best practices to help empower client employees; helped refine models based on feedback from internal and external governance organizations; supported models with academic research to help align the correct model to the correct processes; and provided assistance with model implementation and application.
Click here for a recent video I did on how capital-adequacy positions are becoming crucial in analyst recommendations.