RBI Releases Draft Circular on Model Risk Management in Credit for Lenders

The Reserve Bank of India (RBI) has released a draft circular on August 05, 2024, addressing the management of model risks in credit, focusing on ensuring robustness and prudence in the deployment of credit risk models by regulated entities (REs).

The circular highlights that model outputs inherently carry uncertainties due to assumptions that may not align with real-world scenarios. This exposure to model risk has significant implications for credit risk management, compliance, and reputational risks for REs.

The integration of technology in these models has enabled faster decision-making but has also introduced additional complexities, emphasizing the need for comprehensive understanding, robust validation mechanisms, and appropriate governance.

REs must implement a detailed, board-approved policy for model risk management, covering the entire model lifecycle. The policy should include governance aspects, model development, documentation, validation, change control, and monitoring.

REs must maintain a comprehensive Model Inventory, including all approved models, whether insourced or outsourced. Models can be developed internally or sourced externally. Regardless of their origin, models must adhere to principles that ensure clear objectives, robustness, scalability, and consistency.

REs are responsible for ensuring that outcomes are unbiased, explainable, and verifiable, with a necessary interface with core banking and risk management systems. REs must establish an independent model validation process before deployment and after any significant changes. Validation should include reviewing assumptions, verifying data accuracy, and assessing model efficacy through back-testing. Validation outcomes must be documented and reported to the Risk Management Committee of the Board.

The RBI reserves the right to engage external experts to validate the models deployed by REs, including those sourced from third-party suppliers. REs must include provisions in their contracts to allow such supervisory evaluations.

The draft circular will come into force three months from the date of issuance of this circular. New credit models must comply with these guidelines from that date, while existing models must be validated within six months.

The move aims to strengthen the framework surrounding the use of credit models, ensuring that lenders are adequately managing the risks associated with these tools.