Model Risk versus Model Validation

Model Risk versus Model Validation

Model Risk and Model Validation are related concepts but

• Model Risk refers to the potential for error in the development and implementation of a financial model and/or the application or interpretation of model results. In turn model errors can lead to a variety of financial and / or reputational loss events.
• Model Validation is the set of principles, practices and organizational arrangements supporting a rigorous (audited) model development and validation cycle.

Model Validation is necessary because of Model Risk (both conceptual and implementation issues) but does not eliminate it. Model validation is thus a Risk Mitigation activity and there is always a degree of Residual Risk