Predictive Modeling: Proceed With Caution, Dickson Says

Although some blame inaccurate predictive modeling for last year’s market meltdown, Canada’s top regulator gives the tools the green light, but urges financial institutions to proceed with caution.

The financial institutions that found themselves better insulated from the financial crisis were actually those using modeling in conjunction with strong risk management, Dickson told attendees at KPMG’s 2009 Annual Insurance Issues Conference. “When used properly, financial institutions can get a better handle on risk,” and even put institutions ahead of the game, she said, adding that with modeling, “the emphasis should be more on risk management and less on compliance. Successful institutions are ahead of the regulator in managing their risks.” 
An early warning tool

Long used by P&C and life insurers to determine property risks and liabilities, models are a valuable early-warning tool, Dickson told conference participants, who gathered in Toronto November 26. Any hesitation surround them, she said, should centre on how they’re used.

“We are talking about the need for the institution to understand the extent to which models are being used, and whether there are good processes in place to really focus on what your models are telling you about your business, and perhaps make you question the risks you are taking on,” she noted. “You need to be comfortable that your institution has the processes in place to ensure that your models help to manage risk, not help create risk.”

Dickson also noted that OSFI will put special focus on modeling use in the coming months.

Capital constraints

Companies should proceed with caution, she said, noting that OSFI is watchful of the extent to which financial institutions can use modeling, with less leeway, for example, for banks to set capital; but more to determine operational risk.  Dickson also addressed the school of thought that stresses the diversification benefits between risk categories, and those who say that not taking those benefits into account will make capital requirements too high and uncompetitive.

“OSFI has indicated that we are not prepared to approve models where capital will be reduced due to diversification between risk categories,” she said.  “We have taken this position because it is difficult to reliably prove the correlations between risk categories, and this would be an area where OSFI will have great difficulty in controlling and validating model assumptions.”

Mitigating risk

All financial institutions should take steps to mitigate modeling risk, she added, noting that, “the world does not stop changing the day the model is approved. It makes sense to build in safeguards like periodic model review, and limitations, such as requiring that the model be brought back for examination if the business using the model becomes a lot bigger.”

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