Conducting a Model
Validation for BSA- a Two Part Series- Part Two
As we discussed in the first part of this Series, there has
been an increasing emphasis placed by examiners on the use of BSA/AML
monitoring software. In particular,
regulators expect that when banks obtain monitoring software, they will also
perform regular data and model validations.
We noted in Part One that data validations should be performed by
comparing core system data with the data in the monitoring software. In addition, we noted that the data
validation should be performed with some regularity to prevent long periods
where errors may exist.
Official guidance from the OCC and the Federal Reserve is
the basis for regulators expectations in this area. The guidance that was first published in
2011 directly addresses the use of models as part of a risk and compliance
structure at banks. [1] The guidance notes that the use of models in
banking is both a desirable and useful practice; however, models cannot be
viewed as a complete solution for compliance purposes. Models have to be part of an overall
compliance program. Moreover, models must be validated as to both data accuracy
and applicability. It is not enough to
simply test whether or not the data in your BSA/AML software has been properly
mapped. You must also determine that the
software is doing what the bank needs it to do to monitor suspicious
activity.
Model Validation
The OCC guidance points out that the use of models in any
banking environment must fit within a risk framework. This framework has essentially four elements:
·
Business and regulatory alignment – the model
must fit the bank’s risk profile and regulatory requirements
·
Project management – a proper and appropriate
implementation is an ongoing project that is dynamic as the bank’s operation
·
Enabling Technology – The use of the technology
should facilitate the bank’s ability to meet its regulatory requirements
·
Supporting documentation – As a best practice,
documentation of the rational for using the model should be maintained.
For BSA/AML, monitoring software, the
risk framework means that regulators expect banks to know how its software
works as well as the “blind spots” for
transactions that may not be completely covered by the way the software
operates. The expectations are that
your bank will use monitoring software as a tool that is constantly being
sharpened and improved. The model
validation process is the means to ensure that the software is improving.
Its 11pm- do you
know what your software is doing?
The first consideration in completing a model validation is
to determine just which type of software you are using and how it works; in
other words the conceptual framework of
the software. The most popular types of
BSA monitoring software are:
- Risk based- These are systems that incorporate various
factors such as NAICIS codes, zip codes, volume and frequency to predict
higher risk customers
- Rule based- system that compares transactions to
scenarios that mimic suspicious activity
- Behavior based- These systems establish a “base line
for a customer and track activity that exceeds the baseline
- Intelligent systems- This software is based on decision
trees that follow data that has indicated suspicious activity
- Combination- These systems incorporate two or more of
the above into the software.
It is important to document that the bank is aware of which
type of software it has. Moreover, it is important to document how
this software’s concept aligns with the risk profile of the bank. The model has to be one that has the ability
to discern the transactions that your BSA assessment has identified as higher
risk. Ultimately, the expectation is
that you will be able to document what it is that your software is monitoring and
how it is keeping track of your risky transactions. You should be able to document just how
alerts are created and what they mean.
Are you getting a report when a customer sends a wire for the first
time? How about the first time a wire
goes to a foreign country? Does the
software have the ability to track and aggregate ALL transactions associated
with one customer and her affiliates?
Along the same lines, it is critical that a gap analysis is
performed to determine where the system has “blind spots”. Are there transactions such as a transfer of
funds between two customers that are not being picked up by the software? What if someone cashes a check and gives it
to another customer. Will your software
be able to make that determination if this is the sort of transaction that
occurs at your bank and is considered risky?
Ultimately, the conceptual framework of the software that you are using
must match the products, customers and transactions of your bank.
Practice Makes
Better (Never Perfect)
Many banks that have contacted us have been shocked to find
that they have been criticized for keeping the default settings of the
software. We are being conservative; the
logic goes, by keeping the settings of our software as wide and open as
possible. However, this is most
certainly not a best practice. The use
of models is supposed to be a tool that enhances the ability of the BSA staff
to determine suspicious activity and act on that information as is
necessary. Default settings do not
reflect the risk profile of an individual bank and often lead to a large number
of alerts. When alerts are generated for
transactions that are clearly ordinary or not at all suspicious, the output from
the software becomes ineffective as the
BSA staff spends hours on superfluous data.
The model has to be trained to know the risk profile of the bank and to
look at data that is outside of that profile.
Therefore, as a part of a model validation, it is necessary to review
the rules or settings in place and to adjust to optimize the software. This process should be based upon both the
experience of the BSA staff as well as by doing comparative testing. An effective means of optimization and tuning
is to back test several accounts. Using core data, a staff member can ensure
that all transactions that should be considered suspect are being noticed by
the software with alerts.
Who is Minding the
Store?
The guidance from the
OCC and the Federal Reserve also makes clear that a critical component of model
risk management is output analysis. The
best data in the world will be very ineffective in the hands of a staff member
who does not know how to interpret it.
Moreover, the staff that receives and analyzes data must also have the ability to act on
their conclusions. The output of
monitoring software should be reported to senior management on a regular basis
along with information about the actions taken in response to the data. It is not simply enough to show that the
software is creating alerts that result in a suspicious activity report
(SAR). The expectation is that at some
point when a customer has received multiple SAR’s, the data will be reported to
senior management and a decision should be made whether or not to continue the
relationship with the customer.
Governance (It
ALWAYS Comes Down to This!)
Ultimately, model validation comes down to the overall
governance being practiced at a bank.
Models are only as effective as the structure in which they are
used. The guidance notes that there has
to be governance structure that surrounds the use of monitoring software. This structure should include:
a.
Senior
Management and Board Involvement – through regular reporting to the Board
or a committee of the Board
b.
Policies
and Procedures – which should be updated on an annual basis
c.
Roles and
Responsibilities – the staff who are responsible for reading and
interpreting the data should be designated by the Board.
d.
Enterprise
Risk Management and Reporting – the software must be dynamic and should
change along with the risk profile of the bank.
e. Independent
Audit and Testing-
The overall model’s effectiveness should be reviewed and tested regularly by an
independent party.
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