Regulatory Principles for Credit Risk Models by RBI

The Reserve Bank of India recently announced that entities under its regulation must follow specific principles when utilizing credit models to ensure prudence and robustness.

• 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 regulated entities to model risk, which has implications on prudential aspects of credit risk management, compliance, and reputational risk.
• Regulated entities are required to create a board-approved policy for all risk management model frameworks, including justification for adopting third-party models and covering the entire life cycle of any model.
• The RBI recently advised non-bank finance companies (NBFCs) against excessive reliance on algorithm-based credit models and cautioned against over-lending in specific segments.
• All deployment and modifications of individual credit models will need approval from the risk management committee of the entity's board.
• Every model must undergo validation before deployment and subsequent adjustments due to material events or regular reviews.
• Models, whether developed internally or by a third party, must undergo a yearly review and entities must establish an independent vetting or validation process.
• The release stated that models deployed by regulated entities will be subject to supervisory review, with the circular taking effect three months from its issuance.

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Conclusion:

The regulatory principles outlined by the RBI aim to enhance the transparency and accountability of credit risk models among regulated entities, safeguarding against potential risks and ensuring sound risk management practices.

Tags:

Regulatory Principles, Credit Risk Models, RBI, Risk Management