Finance executives are dependent upon modeling processes for a variety of needs—financial reporting, performance analysis, capital planning and budgeting, regulatory requirements, M&A, etc. Many of these models are used on a recurring basis, employing both accounting and financial theory and technique, and drawing from myriad input data sources.
When we consider the dollar exposure these models represent and the number of times our recurring models are used, we realize the corporate finance function is beholden to the quality of our financial modeling and analysis. Yet, a problem lies hidden in here.
Nearly everyone in corporate finance believes that they know how to model. However, many of us never actually learned financial modeling in a formal manner, as one might at an investment bank or a Big 4 firm. For many, modeling has simply been whatever we’ve made it to be and our preferences have been just fine. After all, they were our models. Adding to this, many of us also learned in siloed corporate environments, as opposed to today’s increasingly collaborative environs with open-ended architectures. This combination has too often led companies to operate on a model foundation hampered by a lack of standardization, key person dependency, inefficiencies, errors, and overall suboptimization. That’s what we grew up with.
But when we begin to view our models not as individually-owned downloads or spreadsheets, but rather as wing-to-wing decision-making processes (inputs-calculations-final outputs), we are better able to align entire work processes with our overall corporate financial objectives, and at lower risk. When you lower risk and increase returns, you are not just operating more profitably, you are shifting the yield curve. With the recent increasing adoption of enterprise risk management, financial model governance is now beginning to grab a stronger foothold in corporate America. As mentioned in the AFP’s recent FP&A Guide, Increasing FP&A’s Effectiveness by Integrating Risk Management, 89% of CFOs currently report to the board on risk topics.
FINANCIAL MODEL GOVERNANCE PRACTICES
Current financial model governance practices employed in the financial service industry are the result of a document titled “SR 11-7”, issued by the U.S. Federal Reserve Board and Office of the Comptroller of the Currency in 2011. Financial model governance practices serve as the gold standard for how models are developed, employed and monitored.
The SR 11-7 document was borne from the Great Recession and broadly outlines model risk management, governance, and its primary components. While written for the financial industry, this is not exclusive; non-financial firms have much to gain from practices laid and built upon this directive. Aside from the obvious financial exposure, what exactly are the key benefits to a coordinated financial modeling program corporate-wide?
Lower cost and increased effectiveness through the following benefits:
- Greater executive Insight
- Better transparency
- More consistency
- Proper alignment of modeling processes to corporate strategies
- A streamlined audit process with first and second lines of defense
- More effective communication of challenging theoretical concepts to ensure “comfort”
- Reduced key person dependence
- Reduction in potential user error and possible misuse.
This is the first in a series of articles in which we will explore financial modeling development, use and monitoring wing-to-wing, and we will attempt to provide practical suggestions as to how firms can optimize model output and minimize risk by employing established modeling practices and standards. Our topics will cover:
- What is a financial model?
- Worldwide financial modeling best practices
- Model risk management and governance standards
- Forecast model development techniques.