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Model risk refers broadly to the potential risks arising from reliance on a flawed model to guide decision-making. Financial institutions use a range of models to predict losses, allocate capital and recommend trading actions, for example. Model risk can arise at numerous points in a model’s lifecycle – development, validation, implementation and use. It is often considered a subcategory of operational risk.
As a model is, by nature, a simplified version of reality, there is a risk that one or more factors will fail to be accounted for in its calculations, or will be improperly rendered in the model’s output. Imperfect assumptions derived from these calculations can lead companies to make costly errors.
Perhaps the most famous collective instance of model risk failure was the reliance of many banks on flawed assumptions when pricing complex credit derivatives in the run-up to the global financial crisis of 2008, during which many lost billions of dollars on subprime mortgage investment products.
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