RBI releases draft circular on management of ‘Model Risks in Credit’ for lenders

The Reserve Bank of India on Monday released a draft circular on ‘Regulatory Principles for Management of Model Risks in Credit’ for lenders to address potential risks from use of various models for credit management.

The prescriptions in the circular are aimed at ensuring robustness in the process of model deployment by lenders (regulated entities/ REs) for credit decisions.

Credit risk model refers to any quantitative method that applies statistical, economic, financial, or mathematical principles and assumptions to process data into an output to be used for credit decisions.

RBI noted that lenders currently use various models as part of the credit management lifecycle for borrower selection, credit scoring/ rating, pricing, risk management, loan loss provisions, etc.

It emphasised that inherently, model outputs are exposed to uncertainties as they are based on assumptions which may not manifest in the envisaged ways and may take different forms in a real-world scenario.

“This potentially exposes the REs to model risk, which has implications on prudential aspects of credit risk management, compliance and reputational risk.

“While the application of technology in models has facilitated faster decision-making under complex scenarios, it also adds complexity to the model risk management framework, implying the need for a comprehensive understanding, a robust validation mechanism, as well as appropriate governance and oversight,” RBI said.

The central bank wants the lender to put in place a detailed board-approved policy with regard to the framework for all models deployed, covering the entire model life cycle.

RBI said the models used by the REs may either be developed internally or sourced from external third-party suppliers, including under collaborative lending arrangements, or can be a mix of both under the provisions of the policy.

For model development and deployment, the broad principles to be followed should take into account its objectives, problem statements and solution sought from the model should be clearly defined.

“The model shall have the necessary interface with a core banking/ financial system, liquidity management, asset liability management (ALM) or any other risk management system of the RE. Outcomes of the model shall be consistent, unbiased, explainable and verifiable. The same shall form part of the model validation framework,” the circular said.