Model Risk Committees

Model Risk Committees are specialised governance bodies within financial institutions responsible for overseeing the development, validation, use and control of quantitative models used in decision-making. In the context of banking, finance and the Indian economy, these committees have gained growing importance due to increased reliance on complex models for credit assessment, market risk measurement, stress testing and regulatory compliance. Their role is central to ensuring financial stability, transparency and prudent risk management.

Concept of Model Risk and Governance

Model risk refers to the potential for adverse consequences arising from decisions based on incorrect, misused or poorly designed models. Financial models are widely used in banks for credit scoring, asset–liability management, capital adequacy assessment and forecasting. Errors in assumptions, data quality or implementation can lead to significant financial losses and systemic risks.
Model Risk Committees form a critical part of the internal governance framework designed to mitigate these risks. They provide structured oversight to ensure that models are fit for purpose, appropriately validated and aligned with the institution’s risk appetite and regulatory expectations.

Structure and Composition of Model Risk Committees

Model Risk Committees are typically constituted at the senior management or board level within banks and large financial institutions. Their composition often includes senior executives from risk management, finance, compliance, internal audit and business units, along with quantitative specialists.
Key characteristics of these committees include:

• Independence from model development teams
• Clear reporting lines to senior management or the board
• Defined mandates covering approval, review and escalation

Such a structure ensures objectivity and reduces conflicts of interest in model-related decisions.

Functions and Responsibilities

The primary responsibility of a Model Risk Committee is to oversee the entire model lifecycle. This includes approval of new models, periodic review of existing models and monitoring of model performance.
Core functions typically involve:

• Reviewing model assumptions, methodologies and limitations
• Approving validation results and remediation plans
• Monitoring model usage and compliance with internal policies
• Escalating material model risks to senior governance forums

Through these functions, the committee ensures that models support sound decision-making rather than amplify risk.

Role in Banking Operations

In modern banking, models underpin critical operational and strategic functions. Credit risk models influence lending decisions, pricing and capital allocation, while market risk models affect trading limits and valuation. Operational risk models inform capital buffers and loss projections.
Model Risk Committees ensure that these models are not only technically robust but also used appropriately by business units. This is particularly important in preventing over-reliance on automated outputs without sufficient human judgement, a risk that increases with digitalisation and advanced analytics.

Regulatory Context in India

In India, model risk governance is shaped by regulatory expectations and supervisory guidance issued by the Reserve Bank of India. Banks are required to maintain strong internal control systems, including independent risk management and validation frameworks.
Global regulatory standards, such as those developed by the Basel Committee on Banking Supervision, also influence Indian banking practices. These standards emphasise sound model governance, stress testing and capital adequacy, reinforcing the need for dedicated oversight mechanisms like Model Risk Committees.

Importance for Financial Stability

At a systemic level, weak model governance can contribute to financial instability. Inaccurate risk models may underestimate credit losses or market volatility, leading to insufficient capital buffers and heightened vulnerability during economic stress.
Model Risk Committees act as a safeguard by challenging assumptions, ensuring conservative calibration where necessary and promoting transparency in risk measurement. Their role becomes particularly critical during periods of economic uncertainty, when model performance may deviate significantly from historical patterns.

Relevance to the Indian Economy

India’s banking sector operates in a complex and diverse economic environment characterised by varying borrower profiles, data limitations and rapid structural change. Models developed in stable or developed markets may not always be directly applicable to Indian conditions.
Model Risk Committees help contextualise model use within domestic realities, ensuring that risk assessments reflect sectoral, regional and cyclical factors specific to the Indian economy. This supports more accurate credit allocation and reduces the likelihood of systemic stress arising from model-driven misjudgements.

Interaction with Technology and Advanced Analytics

The growing use of artificial intelligence, machine learning and big data analytics has increased both the power and complexity of financial models. While these technologies enhance predictive capabilities, they also introduce new risks related to opacity, bias and explainability.
Model Risk Committees play a crucial role in evaluating such advanced models, ensuring transparency, interpretability and ethical use. They also oversee governance frameworks for data quality and algorithmic accountability.