UK Prudential Regulation Authority Consults on Principles for Assessing Stress Test Model Risk Management Practices

The Prudential Regulation Authority has launched a consultation on model risk management principles for stress testing. The PRA is proposing a set of four principles which are intended to assist firms in developing and implementing policies and procedures to identify, manage and control the risks inherent in the use of stress test models. The principles will be set out in a new Supervisory Statement entitled "Model risk management principles for stress testing", a draft of which is provided in the annex to the consultation paper. The Supervisory Statement would present the PRA's expectations on the model risk management practices firms should adopt when using stress test models.

The four proposed principles are that:
1. Banks have an established definition of a model and maintain a model inventory.
2. Banks have implemented an effective governance framework, policies, procedures and controls to manage their model risk.
3. Banks have implemented a robust model development and implementation process, and ensure appropriate use of models.
4. Banks undertake appropriate model validation and independent review activities to ensure sound model performance and greater understanding of model uncertainties.

The proposed principles would apply to firms participating in the annual concurrent stress test in full and to other firms on a proportionate basis, taking into account their size, complexity, risk profile and the relevance to them of using stress test models. The PRA's proposals are relevant to PRA-authorized banks, building societies and PRA-designated investment firms. The PRA is not currently proposing to extend the principles to insurance or reinsurance firms.

The PRA proposals reflect similar steps being taken by the European Banking Authority, as well as authorities outside of the EU, such as those in the US and Canada. The EBA is proposing new detailed guidance for firms designing and conducting a stress testing programme. The new Guidelines will replace the existing 2010 Guidelines on stress testing published by the Committee of European Banking Supervisors. The proposed Guidelines cover the organization of stress testing, the types of stress test exercises, the reverse stress testing process for regular stress testing and recovery planning purposes, business models, data aggregation, risk and litigation costs, FX lending risk and the interaction between solvency stress tests and liquidity stress tests. The EBA aims to finalize these guidelines during the first quarter of 2018 and intends for the application date to be in the second quarter of 2018.

The PRA invites feedback on its proposals by March 6, 2018. It is particularly interested in feedback on the proposal to apply the proposed principles to firms not participating in the BoE's annual concurrent stress test. The proposed implementation date is June 1, 2018. The PRA proposes that firms should assess their stress test model risk management practices against the principles and report the findings from January 1, 2019. Firms participating in the annual concurrent stress test would be required to assess their stress test model risk management practices from Q3 2018 onwards.

View the consultation paper.

View the EBA's consultation paper.