Draft Circular for Comments on Regulatory Principles for Management of Model Risks in Credit

Introduction

On August 5, 2024, the Reserve Bank of India (RBI) issued a draft circular (RBI/2024-25/DOR.STR.REC.21.04.048/2024-25) for comments. This circular targets all commercial banks, cooperative banks, non-banking financial companies (NBFCs), and other regulated entities, introducing regulatory principles for managing model risks in credit.

Overview

Regulated Entities (REs) extensively use models throughout the credit management life cycle, from borrower selection and credit scoring to risk management and credit loss provisions. These models, though beneficial, are inherently exposed to uncertainties due to underlying assumptions. Consequently, this exposes REs to model risk, affecting prudential aspects of credit risk management, compliance, and reputational risk.

Key Regulatory Principles

1. Definition of Credit Risk Models

?? - A credit risk model is defined as any quantitative method that processes data into outputs used for credit decisions. This includes credit scoring, borrower selection, loan pricing, risk analysis, and estimating loan loss provisions and economic capital.

2. Governance and Oversight

?? - REs must establish a comprehensive Board-approved policy for model risk management covering the entire model life cycle.

?? - Detailed governance, oversight aspects, model development, documentation, validation, and change control processes must be outlined in the policy.

?? - An inventory of all approved models, both insourced and outsourced, should be maintained.

3. Model Development and Deployment

?? - Models can be developed internally or sourced externally, adhering to the outlined principles.

?? - Clear objectives, robust inputs and assumptions, detailed documentation, scalability, and integration with core systems are essential.

?? - Outcomes should be consistent, unbiased, explainable, and verifiable.

?? - REs are accountable for outsourced models, requiring access to technical documentation.

4. Model Validation Framework

?? - Independent validation processes are required to assess model robustness.

?? - Models must be validated before deployment, after significant changes, and at least annually.

?? - Validation includes reviewing assumptions, verifying data accuracy, regulatory compliance, and assessing model outcomes through back-testing.

?? - Validation results should be benchmarked and reported to the Risk Management Committee of the Board (RMCB).

5. Supervisory Review

?? - The RBI will conduct supervisory reviews of models, potentially involving external experts.

?? - Contractual provisions must enable supervisory evaluations of external models.

Implementation Timeline

The circular will come into effect within three months of issuance. New credit models must comply immediately, and existing models must be validated per the guidelines within six months.

Repealed Instructions

The draft circular repeals specific instructions from the Guidance Note on Credit Risk Management issued on October 12, 2002.

Conclusion

The draft circular aims to ensure prudence and robustness in the use of credit models by laying down broad regulatory principles for managing model risks. Stakeholders are invited to provide comments and feedback on these proposed regulations to enhance the effectiveness of credit risk management frameworks in the financial sector.