Model risk and your friendly local regulator July 20, 2011 at 1:02 pm

From a fascinating article at AllAboutAlpha (HT FT Alphaville):

[There was a] settlement early this year between the Securities and Exchange Commission (SEC) and the AXA Rosenberg Group LLC (ARG), along with other entities affiliated with ARG…

The specifics of the problem alleged by the SEC turn on the distinction between Barr’s [an affiliate of ARG’s] Risk Model proper, and a separate system, called the Optimizer, a program that took data generated by the Risk Model and used it to recommend an optimal portfolio for a particular client based on a benchmark chosen by that client, such as the S&P 500.

SEC charged that after the Risk Model update in 2007, two programmers goofed. They were assigned the task of writing code that would link the new version of that program with the Optimizer. Their coding reported some information to the Optimizer in a decimal form, though other information was expressed as percentages. As a consequence, the Risk Model was working at a less than optimal level from April 2007 onward.

There was no independent quality control of their work. Matters seem to have rolled along in their sub-optimal way until June 2009, when another version of the Risk Model was to be introduced. A new Barr employee “noticed certain unexpected results” when comparing the 2009 model then under preparation to the older 2007 model.

He presented his findings to a Senior Official of Barr later that month and advocated that the error be fixed immediately. But the Senior Official said that it would be fixed with the new model was implemented, that September, and in the meantime told other Barr employees to keep quiet about the discovery, and in particular not to inform ARG’s Global Chief Investment Officer.

It wasn’t until late November 2009 that a Barr employee informed ARG’s Global CEO that there ever had been such an error. Thereafter, that company conducted an internal investigation and disclosed the situation to the SEC examination staff. In April 2010 it took the next step, informing its clients.

None of these entities (ARG, ARIM, and Barr) have admitted or denied any wrongdoing. Together, though, they consented to the entry of an SEC order that assigned joint and several liabilities of $25 million and that separately demanded that they pay $217 million to the clients of ARIM and other advisers affiliated with ARG to redress harm from the coding error.

Does this remind you of the ratings agency CPDO snafu? It is striking that time and time again folks make the assumption that models are somehow internal and proprietary and that if an error is made in one then no one need be told. The SEC’s actions hopefully act as reminder that a fiduciary duty can extend to not providing clients with misleading numbers, and that if your financials depend on model calculations, then you probably have to tell someone if those are materially wrong. JPM’s $3B of model risk reserves make a lot of sense in this context.

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