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Zeliade White Paper March, 2010

Zeliade Systems

In July of 2009, the Basel Committee on Banking Supervision issued a directive requiring that financial institutions quantify model risk. The Committee further stated that two types of risks should be taken into account: “The model risk associated with using a possibly incorrect valuation, and the risk associated with using unobservable calibration parameters”. The resulting adjustments must impact Tier I regulatory capital, and the directive must be implemented by the end of 2010. On the surface, this seems to be a simple adjustment to the market risk framework, adding model risk to other sources of risk that have already been identified within Basel II. In fact, quantifying model risk is much more complex because the source of risk (using an inadequate model) is much harder to characterize. Twelve months away

from the deadline, there is no consensus on this topic. There is fortunately a growing body of literature, both from the academia and the industry, and the purpose of this paper is to summarize the development of the notion of “model risk” and present the current state of the art, before outlining open issues that must be resolved in order to define a consistent framework for measuring model risk.

http://www.zeliade.com/whitepapers/zwp-0006-ModelValidation.pdf

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