Prudential Regulation Authority Rulebook

6.1

This chapter sets out the PRA’s expectations regarding the role of the non-executive directors (NEDs) when considering a firm’s internal model.⁶ 

6.2

The use test⁷ is one of the T&S firms need to meet. As part of the use test, firms must ensure that members of the board and others involved in running the firm have an understanding of the model.⁸ One of the methods the PRA may use to assess whether firms are meeting the use test is to speak to NEDs (either individually or collectively) to gauge their understanding. The PRA does not believe that it is necessary for board members to be technical experts in modelling techniques in order to meet the use test requirements. Rather, the PRA expects board members to understand and be able to explain areas such as the:

• key strengths, limitations, and judgements within the model;
• assumptions and judgements that have the most material impact on the model output; and
• key sources of information and advice the board has relied upon in order to satisfy itself about the appropriateness of both the model design and the model output.

6.3

Board members should be supported by the executive management to understand and engage with the key features of models. Boards should draw on a wide range of sources to understand, challenge and make a decision on the validity of a model. For example, independent validation can play an important role in helping boards gain an overall understanding of a model and its strengths and limitations, as long as the validation work is focused appropriately on a critical appraisal of the most material aspects of the model, and if its conclusions are summarised and presented appropriately for a board-level audience.

6.4

Under the leadership of the chair, NEDs should consider and challenge, as appropriate, the executive management on all aspects of the firm’s strategy, which includes the viability and sustainability of the business model and the establishment, maintenance and use of the risk appetite and management framework. NEDs are expected to challenge how these elements are reflected in the internal model.

6.5

The executive management should be able to explain the firm’s internal model in simple and transparent terms to NEDs. This includes explaining the uncertainty around judgements, in what circumstances the results may deteriorate (eg the analysis or strategy could be wrong), and the implications on the internal model of different methods of measurement for issues such as liquidity. In order to explain complexity to the NEDs, the executive management should provide good management information to enable challenge and thus encourage accountability. If NEDs do not feel that they can meet these expectations, they should demand the time and support to enable them to do this.