Model reviewModel review

Model review

When reviewing an internal model (both prior to and after model approval), APRA will consider whether:

1. the internal validation processes are operating in a satisfactory manner;

2. the formulae used in the calculation process and for the pricing of options and other complex instruments are validated by qualified parties, who are independent from the trading area and not involved in the development or implementation of those formulae;

3. the structure of the internal model is adequate with respect to the ADI’s activities and geographical coverage;

4. the results of the ADI’s back-testing of its internal measurement system ensure the model provides a reliable measure of potential losses over time;

5. data flows and processes associated with the risk measurement system are transparent and accessible, in that the model’s specifications and parameters can be easily accessed; and

6. the ADI has processes to ensure that its internal models have been adequately validated by suitably qualified parties independent of the development process to ensure that they are conceptually sound and adequately capture all material risks. This validation must be conducted when the model is initially developed and when any significant changes are made to the model.

   An ADI must validate its internal models on a periodic basis but especially where there have been any significant structural changes in the market or changes to the composition of the portfolio that might lead to the model no longer being adequate. As techniques and best practices evolve, an ADI must avail itself of these advances. Apart from back-testing, model validation must, at a minimum, also include:

7. tests to demonstrate that any assumptions made within the internal model are appropriate and do not underestimate or overestimate risk;

8. the use of additional back-tests; and

9. the use of hypothetical portfolios to ensure that the model can account for particular structural features that may arise.