Unaccounted model risk for Basel IRB models deemed acceptable by conventional validation criteria

Validation procedures are designed to prevent IRB models with model risk from being used in day-to-day business operations. The models that do pass are expected to entail negligible model risk. However, no one has studied the magnitude of such risk. Moreover, most of the prior literature criticises the IRB models either for missing certain features (such as concentration) or for being overconservative due to reliance on the 99.9% confidence level. By simulating around 700 scenarios for the hypothetical loan book, we are able to demonstrate the materiality of the model risk of the accepted IRB models. In addition, we explain that the accuracy of the conservative margin adjusting model calibration cannot offset the underlying model risk when the discriminatory power is not perfect (which is almost always the case). Ultimately, we arrive at suggested risk-weight (RW) mark-ups which enable the revealed and previously unaccounted for IRB model risk to be captured.