Model Risk Management and Basel III Capital

Every price, risk number and credit decision a financial institution produces depends on models, and every model can be wrong or used wrongly. Model risk management is the discipline of finding and controlling those errors. Since US supervisors issued their SR 11-7 guidance in 2011, it has become a function of its own in banks and a growing concern for asset managers and trading firms.

What does a model validator actually do?

A validator checks three things independently of the people who built the model. Is the theory and design sound for its purpose? Is it implemented correctly, which often means rebuilding it? And do its outputs match reality, tested by benchmarking against alternative models and by comparing predictions with outcomes? The findings go into a report graded by severity.

How much of a model’s risk comes from how it is used?

Often more than from the model itself. A model built for one portfolio or market regime is applied to another, or its limitations are forgotten as it is passed between teams. The course treats use and governance as part of the risk, not an afterthought.

What changed with the Fundamental Review of the Trading Book?

Basel III sets how much capital a bank must hold against the risk of its trading positions. The rules decide which trades are profitable after capital, which desks may use their own models, and how risk is reported to regulators. This course explains the market risk part of the framework and works the calculations.

It replaced Value at Risk with expected shortfall for internal models, introduced liquidity horizons so that hard-to-sell positions carry more capital, made the standardized approach sensitivity-based, and added strict tests that each desk must pass to use its own model. Banks spent years implementing it, and the work continues.

Who is this course for?

Risk analysts, quants moving into validation, and model developers who want to know what validators look for.

What you will be able to do

• Define model risk and identify its main sources.
• Set up a model inventory with risk tiering.
• Plan and carry out a validation covering soundness, implementation and outcomes.
• Design ongoing monitoring with thresholds and escalation.
• Write a validation report with findings graded by severity.
• Explain the structure of Basel III capital and where market risk fits.

Syllabus, module by module

1. What model risk is

   Fundamental errors, implementation errors and misuse; well-known model failures.

2. Supervisory guidance

   The US SR 11-7 guidance and comparable expectations elsewhere, in outline.

3. Inventory and tiering

   Defining a model, recording it, and tiering by materiality and complexity.

4. Why banks hold capital

   Basel I to III, capital ratios and the place of market risk.

What every course contains

Every paid course comes with the first seven and the certificate, whichever level it sits at. The proctored exam and the credential come when the course is taken as part of a Certificate, Diploma or Fellowship. Everything is self-paced: the material is yours to study in any order, at any hour, for the whole of the license.

1. Workbooks. Written to train the thinking patterns and the important concepts of the course, with worked problems and the reasoning behind each answer, so that you learn to think the way the subject is thought.
2. Audio edition. Focused, well-presented recordings with explainers and examples of the material, made to be interesting, relevant and entertaining, so that the general subject can be learned away from the desk.
3. Notes. Pre-produced notes with every fact the course relies on, written out in full, so that nothing has to be transcribed from the films or the audio.
4. Cheat sheet. One sheet with every important learning concept of the course on it, to keep beside you during the work and to revise from before the exam.
5. Named sources. Every fact in the notes names its source, the paper, the book or the dataset, for anyone who wants to dig in further.
6. Explainer films. Focused films, in the style of the sample films on the catalog page, that walk through the most difficult concepts of the course with visual explanations of a high standard.
7. Transcript. A full transcript of every film and every audio recording, searchable and quotable.
8. Proctored exam. Taken as part of a Certificate, Diploma or Fellowship, the course ends in a proctored multiple-choice questionnaire, with a pass mark of 60% and three retakes included. A course taken on its own is assessed by its coursework and has no exam.
9. Verifiable certificate. A certificate of completion that a third party can verify: an employer sends the code on it to the credentials office and receives written confirmation of the course, the date and the result.
10. Credential of the program. The Certificate, Diploma or Fellowship of the program, track or path the course belongs to, awarded when every course in it is passed. Which one depends on the program you choose.

How the certificate is earned

An assessed project: you validate a supplied pricing or risk model, including replication, benchmarking and outcomes analysis, and submit your code and a validation report. On a pass you receive the Course certificate in Model Risk Management and Basel III Capital, issued by the Institute with a verification code. A course taken as part of a Certificate, Diploma or Fellowship ends in a proctored online exam with a pass mark of 60%. The fee includes three retakes; each attempt after that carries a reduced proctored exam fee. A course taken on its own is assessed by its coursework and has no exam. Read how certification works.

Before you start

This course assumes the material of the courses below, or the same knowledge gained elsewhere.

• Probability for Quantitative Finance, with Statistics
• Value at Risk, Expected Shortfall and Stress Testing