In an effort to guarantee procedural prudence and robustness, the Reserve Bank of India (RBI) sent a circular to all banks and non-bank financial institutions (NBFCs) on Monday, outlining new regulatory rules for the management of model risks in lending.
Throughout the credit management life cycle, Regulated Entities (REs) employ a variety of models for borrower selection, credit scoring and rating, pricing, risk management, credit loss provisions, and other related tasks.
According to the RBI, model outputs are inherently subject to uncertainty because they are predicated on assumptions that might not materialize as intended or take on other shapes in actual situations.
The RBI went on to say that this could expose the REs (banks, NBFCs, and home finance companies) to model risk, which could have an impact on reputational risk, compliance, and prudential aspects of credit risk management.
A regulated firm must create a board-approved policy for each risk management model framework it uses, according to the RBI, including the justification for using a third-party model.
The RBI said that the board of the entity’s risk management committee would have to approve the implementation of each particular credit model and any ensuing modifications.
According to the RBI, the circular would become operative three months after it is issued.
With effect from the aforementioned date, REs adopting new credit models must abide by these principles, and models already in use must be verified in accordance with these criteria within six months of the circular’s release date.
The RBI recently cautioned NBFCs against relying too much on algorithm-based credit models, which brings us to the laws.
Although the use of technology in models has made it possible to make decisions more quickly in complex situations, it has also increased the complexity of the model risk management framework, indicating the need for appropriate governance and oversight, a strong validation mechanism, and a thorough understanding, as noted by the RBI.
