Definition
Model risk arises when models produce inaccurate results due to incorrect assumptions, implementation errors, or misapplication. The 2008 crisis revealed catastrophic model failures: CDO pricing models assumed housing prices couldn't decline nationally. Model risk management requires independent validation, backtesting, stress testing of model assumptions, and governance oversight.
lightbulb Example
Pre-2008 CDO models assumed mortgage default correlations of 20-30%. Actual correlations exceeded 80% during the crisis, causing models to massively underestimate risk. Trillions in losses resulted from this model failure.
verified_user Key Points
- Flawed assumptions can cause catastrophic losses
- 2008 crisis was partly a model risk failure
- Independent model validation is essential
- Models should be regularly backtested and stress tested