Model Taxonomy is a classification and documentation system for the (financial / risk) models used by an institution.
A model taxonomy might be the organizing principle behind a Model Inventory system.
By Type of Financial Models
Despite the huge variety of models, there are only very few major conceptual classes of financial models in use today. Two major and recognized classes are as follows:
- risk models that use empirical data (historical, market data, expert input etc.) to create a projected scenario set for future outcomes
- valuation models that use some market observables and possibly further assumptions to value current positions, whether liquid or illiquid. This class contains also the sub-class of "no-arbitrage" pricing/valuation models that use assumptions about market behavior to calculate a unique theoretical for derivative products
These categories are linked primarily to model use (see below).
The first class uses mostly historical information about prices or other risks factors to forecast future prices/risk factors.
The second class uses future forecasts embedded in current asset prices to construct prices for less liquid or more complex assets.
A third class of models can be termed "business support" models. This is a large and diverse collection of quantitative models and tools that may be used to assist with pricing, trading, structuring, marketing or any other business / management purpose not linked to risk management or valuation / financial reporting.
By Model Use
- Acceptance of risk
- Pricing of risk
- Risk control (use in risk limits)
- Hedging of risk (hedge size)
- Portfolio Management of risk (risk attribution)
- Capital buffers for risk
- Valuation / PnL calculation
By Business Activity
Different business activities typically lead to different collections of models and different solutions to seemingly similar requirements. The factors that underpin this phenomenon are:
- The prevalent risk type in the business activity. E.g. trading businesses tend to see and treat all risks as "market risks"
- The prevalent account regime in the business activity. E.g. accrual accounting skews the perceptions of credit deterioration risk in many commercial and retail banking activities
The classification of business lines follows the Basel II taxonomy
- Commercial Banking
- Retail Banking
- Corporate Finance
- Trading and Sales
- Payments and Settlement
- Asset Management
- Retail Brokerage
By Risk Type
Risk types (market, credit, operational etc.) and corresponding risk taxonomies are a natural taxonomy also for risk model classification.
- Market Risk
- Credit Risk
- Operational Risk
- Business Risk
- ALM Risk
The classes are then subdivided further, e.g. by market risk factors, default versus recovery risk , nature of operational event etc.
By Client Type
This is primarily useful in connection with credit risk
- Sovereigns (and associated)
- Individuals (with possible wealth split)
By Product Type
Products tend to be specific to business lines / clients. The factors that drive product specific models are
- Legal context (bilateral versus securities)
- Purpose and optionality / complexity
Linkages with other taxonomies
Each one of the preceding classification dimensions links the model taxonomy with other organizational schemes used by the firm, for example, risk models are naturally linked with the Risk Taxonomy.