Financial institutions like banks and bank holding companies use models to simulate a variety of financial situations and market conditions. The goal of financial modeling is to determine what conditions a certain investment, portfolio, or business process can no longer operate under effectively. Models used for budgeting, determining event probabilities, analyzing financial statements, and examining product pricing are often exceedingly complex, and therefore carry risk.
Model risk management refers to the potential for adverse consequences from decisions based on incorrect or misused outputs and reports. With technological advances, increasing regulatory requirements, and various other internal and external forces, models have been increasing in both number and complexity. This increase has resulted in a greater need for proper model risk management, or the process of identifying, assessing, and mitigating these risks.