The Reserve Bank of India (RBI) released draft guidelines on 5th August 2024 on "Regulatory Principles for Management of Model Risks in Credit”. The guidelines shall come into force within three months from the date of issuance to improve model risk management (MRM) protocols for Regulated Entities (RE). The guidelines address the increasing complexity and potential vulnerabilities in credit decision models.
The circular defines Credit Risk Model as 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.
Credit decisions encompass all aspects of managing credit exposure, including but not limited to credit scoring and selection of borrower, pricing of loan, risk assessment for different types of loans, and the estimation of loan loss provisions and economic capital.
RE uses different models throughout the credit management process. In credit management, models are used for tasks like selection of borrower, scoring, rating credit, credit losses and risk management, but they rely on assumptions that can lead to inaccuracies. AI models, while useful, can inadvertently perpetuate biases present in historical data, resulting in potentially unfair lending practices.
This also makes managing model risk more complex, requiring a deep understanding, strong validation processes, and proper governance and oversight. To ensure that these models are used wisely and effectively, new broad regulatory principles have been established, which are as follows:
Governance and Oversight: RE must establish a comprehensive Board-approved policy for managing model risk, covering governance, development, documentation, validation, change control, and monitoring. This policy should also address the use of third-party models and include a Model Inventory with key details. Any deployment or changes to credit models must be approved by the Board's Risk Management Committee (RMCB) or another designated sub-committee.
Model development and Deployment: Models used by RE, whether developed internally or sourced externally, must have clearly defined objectives, robust inputs and assumptions, and comprehensive documentation. They should be scalable, flexible, and integrated with relevant systems, ensuring consistent, unbiased, and explainable outcomes. Outsourced models must adhere to these principles, with RE remaining accountable for their integrity and outcomes.
Model Validation Framework: RE must implement an independent model vetting process for validating models before deployment and after significant changes, with annual reviews. Validation should include assessing assumptions, data accuracy, regulatory compliance, and model effectiveness through back-testing. Validation Outcomes must be clear, easy to understand and compared to policy benchmarks and reviewed by the Risk Management Committee. Additionally, the Reserve Bank may review models, including those from external sources or third parties.
Review: Models should be reviewed at least once a year.
The absence of robust MRM can lead to significant financial risk. Models that are not properly managed may produce inaccurate or biased results, leading to poor credit lending and potential financial losses. These guidelines can result in more precise credit assessments, customer trust, mitigating financial risks and preserving the integrity and stability of the financial system. On the other hand, these guidelines will likely increase operational costs for RE, as they need to invest in technology, training and personnel for the new standards.
Instructions issued by RBI-Guidance Note on Credit Risk Management, October 12, 2002, are repealed now. The RBI emphasized that direction is issued under Sections 21, 35A and 56 of the Banking Regulation Act, 1949, Sections 45JA, 45L and 45M of the Reserve Bank of India Act, 1934, and Sections 30A, 32 and 33 of the National Housing Bank Act, 1987.
The existing models shall be validated in terms of these guidelines within six months from the date of issuance of these guidelines, which is 5th August 2024.
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***This blog incorporates and outlines key information from the recent government circular issued on 5 August 2024***
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© 2024 Chandhiok & Mahajan, Advocates and Solicitors
This alert is for information purposes only and does not constitute legal advice.
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