How Banks and NBFCs Must Adapt to New Model Risk Standards
The Reserve Bank of India (RBI) has introduced new regulatory norms aimed at managing model risks in credit operations for banks, Non-Banking Financial Companies (NBFCs), and housing finance companies. These guidelines, which were issued on August 5, 2024, are designed to ensure that the models used in credit processes are robust, reliable, and well-governed.
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The RBI’s move comes in response to the increasing reliance of financial institutions on algorithm-based models for various credit-related activities, such as borrower selection, credit scoring, pricing, and risk management. While these models have improved decision-making speed and accuracy, they also introduce complexities and potential risks due to their dependence on assumptions that may not always reflect real-world conditions.
To address these concerns, the RBI now requires all regulated entities to develop a comprehensive, board-approved policy for the management of model risks. This policy must cover all aspects of model usage, including the rationale for adopting third-party models, the criteria for model approval, and the procedures for ongoing validation and monitoring.
In addition to the policy requirements, the new norms stipulate that any new credit models or significant modifications to existing models must receive prior approval from the entity’s risk management committee. The RBI has set a three-month deadline for the implementation of these guidelines, with six months for existing models to be validated under the new standards.
The introduction of these guidelines is seen as a proactive measure by the RBI to enhance the resilience of the financial sector against model-related risks. It underscores the importance of a robust governance framework in ensuring that credit models are not only effective but also align with the broader objectives of financial stability and risk management.
These regulations reflect the RBI's ongoing efforts to strengthen the regulatory environment in India’s financial sector, particularly in light of the rapid technological advancements that are reshaping traditional banking and financial practices
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