what does the concept of model risk tell you 
any model is a simplified version of reality and with any simplification there is the risk that something will fail to be accounted for assumptions made to develop a model and inputs into the model can vary widely the use of financial models has become very prevalent in the past decades in step with advances in computing power software applications and new types of financial securities before developing a financial model companies will often conduct a financial forecast which is the process by which it determines the expectations of future results some companies such as banks employ a model risk officer to establish a financial model risk management program aimed at reducing the likelihood of the bank suffering financial losses due to model risk issues components of the program include establishing model governance and policies it also involves assigning roles and responsibilities to individuals who will develop test implement and manage the financial models on an ongoing basis real world examples of model riskthe long term capital management ltcm debacle in 1998 was attributed to model risk in this case a small error in the firm s computer models was made larger by several orders of magnitude because of the highly leveraged trading strategy ltcm employed 1 at its height the hedge fund managed over 100 billion in assets and reported annual returns of over 40 ltcm famously had two nobel prize winners in economics as principal shareholders but the firm imploded due to its financial model that failed in that particular market environment almost 15 years later jpmorgan chase jpm suffered massive trading losses from a value at risk var model that contained formula and operational errors risk managers use var models to estimate the future losses a portfolio could potentially incur in 2012 ceo jamie dimon s proclaimed tempest in a teapot turned out to be a 6 2 billion loss resulting from trades gone wrong in its synthetic credit portfolio scp 2 a trader had established large derivative positions that were flagged by the var model that existed at the time in response the bank s chief investment officer made adjustments to the var model but due to a spreadsheet error in the model trading losses were allowed to pile up without warning signals from the model this was not the first time that var models have failed in 2007 and 2008 var models were criticized for failing to predict the extensive losses many banks suffered during the global financial crisis 3 