by Joana Barata

The three lines of defence is the model that financial institutions, particularly (more established) banks, apply to deliver effective model risk management.

Before elaborating further on the three lines, it is important to understand that model risk management is not a sequential process. The process starting from the development of a model and ending in the production of the model, requires multiple back and forth interactions between different stakeholders involved in model risk management. These stakeholders make up the so-called three lines of defence, they are divided according to their roles and responsibilities.

Throughout multiple iterations between these three lines of defence, an organization can assure the quality of models in production. Moreover, this can as well reduce the risk of model failure.

By clarifying roles and responsibilities, the three lines of defence enhances the understanding of governance and risk management. Information is centrally managed and shared, and the activities are coordinated to avoid duplication of efforts and gaps in coverage.

The main driver for the creation of this concept is the regulatory guidance SR11-7 that states the following: “While there are several ways in which banks can assign the responsibilities associated with the roles in model risk management, it is important that reporting lines and incentives be clear, with potential conflicts of interest identified and addressed.”

Although SR 11-7 uniquely refers to banks throughout the document, it is important to notice that other financial institutions have adopted the guidance for their institutions even though they may not have all three lines of defence. For instance, model risk audit is not always there and some model risk activities responsibilities may be outsourced.

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