What is a Model Risk?

A model risk is a type of operational risk that has the ability to impact the operational structure and profit margin of the business that makes use of a given business model. When the business model is based on accurate data and performs according to the expectations set by the firm, the degree of model risk is normally kept at a minimum. In many situations, an effective model allows for some variables that make it possible to compensate to a degree for unforeseen events and keep the model risk within reason.

From this perspective, model risk can be seen as the degree of risk that is associated with developing a specific plan for operation, and following through with that plan. In general, the idea is to assess the risk level and determine if the business model is actually the best course of action, given the projected movement of the economy and the resources that the business has to call upon in order to continue operations. This makes accurately assessing the degree of model risk before the actual implementation of a business operational model extremely important, if the company wishes to function in a manner that is likely to result in the highest revenue generation while keeping the model risk as low as possible.

Inherent in model risk is the understanding that any type of model relies on assumptions that certain events and circumstances will take place, and remain constant for a period of time. For example, when a dairy creates a business model, there is an assumption that the demand for the products it offers will remain above a certain level. There is always the risk that the demand will slip below those minimum figures used to create that model. By recognizing this model risk that is based on the possibility of an assumption to be inaccurate, the company will attempt to develop some sort of backup strategy that would help to offset that risk and increase the potential for remaining profitable.

Thanks to the aid of modern software, assessing model risk is easier than in times past. It is possible to apply any number of variables to the basic assumptions, project the influence those variables could have, and develop strategies that would make it possible to reduce any undesirable affects that those variables could produce under the right circumstances. While there are many strategies that can help reduce the degree of risk, there is no way to completely do away with the possibility that some shift in circumstances would derail the business model entirely, and result in the failure of the business. For this reason, assessing the risk level is an ongoing process that must take into account any and all factors that arise as consumer demand shifts, new technology impacts production efficiency, or even when changes in materials needed to produce goods and services are affected in some manner.